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Why You Might Think Of Investing In This FTSE Underdog: BAE Systems plc

Contrarian investors like to find stocks that are out of favour with the market. When sentiment is negative then the true value of a stock can easily be overlooked. I’m trawling the underdogs of the FTSE to identify which of them may not deserve their sub-market P/E ratings.

Defence contractor BAE (LSE: BA) (NASDAQOTH: BAESY.US) has long been an unfashionable stock. It’s one of a clutch of FTSE 100 firms trading on a prospective P/E of around 10, barely two-thirds of the market average. That’s despite a good run this year, which has seen the shares put on over a third.

Defence spending

Tightened Western defence budgets, including the impact of so-called sequestration budget cuts in the US and the ending of military operations in Iraq and Afghanistan, are the root cause. Despite efforts by the company to boost international sales, civil aviation and cyber-security business, the US Department of Defense and UK Ministry of Defence remain its principal customers, each accounting for about a third of total sales.

A prodigious cash flow, and astute cost-cutting, has enabled BAE to maintain its progressive dividend with cover hovering around two times, with a prospective yield of 4.5%. Indeed the biggest financial risk is its £5.5bn pension deficit, a third of market cap.

So it’s not a bad share to hold during a downturn in its markets.  These could get worse before getting better, with the US committed to reducing military expenditure and another budget ceiling crisis just around the corner.

Bounce back

But if defence spending is out of favour in the West, there is good reason to believe it will bounce back. Non-NATO defence spending is rising from Asia to Africa to the Middle East via Russia. That’s bound, eventually, to prompt a response.

BAE is locked into long-term projects, which the order book of over two years’ sales only partly captures. It has a 17% share in the controversial joint-strike F-35 fighter programme that the Pentagon has jealously guarded from defence cuts. Its management of UK naval dockyards are underwritten by the government for 15 years.

If BAE achieves a satisfactory outcome to price-escalation negotiations on the sale of Typhoon jets to Saudi  Arabia — under a contract dating back to 2007 — then the company expects double-digit earnings growth this year, which will support a £1bn share buy-back. If the renegotiation isn’t successful, the shares could see a pull-back.

 Income

BAE is still a good income stock, even if its markets are far from certain.  The Motley Fool's pick of Top Income Stock is in a more stable sector, so much so that its management expects to increase the dividend in line with inflation 'for the foreseeable future'. Yielding 5.4%, that's a great payout to lock in.  To find out more, you can download this special report.  Just click here -- it's free.

 > Tony owns shares in BAE.