BAE Systems Plc: Buy, Sell Or Hold?

What are the long-term prospects for BAE Systems Plc (LON: BA)?

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I’m always searching for shares that can help ordinary investors like you make money from the stock market.

Right now I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index.

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I hope to pinpoint the very best buying opportunities in today’s uncertain market, as well as highlight those shares I feel you should hold… and those I feel you should sell!

I’m assessing every share on five different measures. Here’s what I’m looking for in each company:

1. Financial strength: low levels of debt and other liabilities;

2. Profitability: consistent earnings and high profit margins; 

3. Management: competent executives creating shareholder value;

4. Long-term prospects: a solid competitive position and respectable growth prospects, and;

5. Valuation: an under-rated share price.

A look at BAE

Today I’m evaluating BAE Systems (LSE: BA)(NASDAQOTH: BAESY.US), a London-based global arms manufacturer, which currently trades at 448p. Here are my thoughts:

1. Financial strength: BAE is in fair financial health. The company has a net debt of over £1bn; ample interest cover of six times; and generates an average of more than £1bn in free cash flow yearly. However, it has a pension deficit of over £4.3bn.

2. Profitability: During the past decade, BAE enjoyed consistent growth right until the global financial crisis hit in 2009. Since then, it saw its revenue and profits decline in two of the last three years. Nevertheless, for the past ten years, the company doubled revenue and more than doubled earnings per share, and operating profit per share. Also, operating margin has been consistently around the high single digits, while return on equity has ranged around the high teens and has increased to the mid-20 to low-30 percent range over the last four years. 

3. Management: The company has a strong history of returning value to shareholders. Dividends per share have increased every year for the past 10 years, while the company has bought back a total of £1bn worth of shares from 2010 to 2011, and is planning to repurchase £1bn more over the next three years.

4. Long-term prospects: In the wake of the global financial crisis, governments around the world reduced defence spending — chiefly, the UK and the US, BAE’s largest customers, accounting for 62% of group revenue in 2012 — which has weighed down on BAE’s profits for the last few years.

To offset the effects of a budget-constrained environment, the company has pursued several strategies. It has moved from an equipment supply-centred model to growing more of its support-services business, which ensures a steadier income stream — as product demand wanes, more customers will look to upgrade and maintain existing equipment instead of purchasing new ones. As of 2012, support services accounted for 50% of group revenue.

Also, the company has been diversifying into higher growth areas such as cyber security and the electronics market, which has been seeing increasing demand lately, and which the company feels have significant growth potential.

Moreover, since 2009, the company has been driving down cost and improving efficiency, reducing its workforce and disposing several non-core segments.

Lastly, the company is looking to capitalise on the growth of international markets, which accounted for 30% of group revenue in 2012. BAE is already the leading defence supplier in Saudi Arabia and Australia, and is developing India into another home market, while also pursuing several opportunities in Malaysia, Oman, United Arab Emirates, and other Gulf states.  

5. Valuation: BAE shares are trading at a forward price-to-earnings (P/E) ratio of 10, slightly below its 10-year median P/E of 11, and a discount to the sector P/E average of 15.

My verdict on BAE

Due to shrinking defence budgets, BAE has struggled to generate revenue growth for the past few years, and it looks like this fiscal environment will continue for the next few years, with more possible cuts in the future. Also, its huge pension deficit is a concern.

However, with its long history of growing revenue and profits, outstanding cash generation, strong positions in its end markets, and being the only major player in the UK, I think BAE will be able to hurdle these difficult times and return to growth. Furthermore, it is trading at attractive valuations –an earnings yield of 10% and a solid dividend yield of 5%, twice covered.

So overall, I believe BAE at 448p looks like a buy.

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In the meantime, please stay tuned for my next verdict on a FTSE 100 share.

> Zarr does not own any share mentioned in this article.

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