Why BAE Systems plc’s Acquisitions Strategy May Be Primed For Take Off

Royston Wild evaluates what an improving defence sector outlook could mean for BAE Systems plc (LON: BA).

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Today I am looking at why I believe BAE Systems(LSE: BA) (NASDAQOTH: BAESY.US) expenditure plans could be set to explode sooner rather than later.

Acquisition activity set to resume?

BAE Systems has been relatively subdued on the M&A scene in recent times, as uncertainty over global defence expenditure has prompted the firm to focus on slashing costs and minimise non-organic investment instead. This sea change saw net capital expenditure slump to £153m last year from £293m during 2012.

Indeed, the impact of reduced defence spend and lumpy contract timings in its core Western markets has crushed profits in recent times, and the BAe Systems Hawk 102Dcompany reported a 65% drop in pre-tax profits to £422m in 2013.

Concerns over the state of the sales ledger looking forward has also prompted BAE Systems to hive off non-core operations. The firm divested its Safariland armour and equipment division — which provides items for law enforcement agencies — in May 2012 for around $114m, as well as its Tensylon High Performance Materials subsidiary for $18m the following month.

However, the revenues outlook for BAE Systems and its peers has picked up significantly in recent months, initially prompted by US lawmakers’ decision late last year to lift the domestic defence budget to $520.5bn. With Western economies seemingly on the mend, and emerging market defence spend also tracking consistently higher, BAE Systems could be tempted back into the M&A fray in the near future.

Promisingly, the company has vast reserves to call upon should it wish to stock up on new acquisitions, even though its hefty cash pile has continued to dwindle. Cash reserves registered at a solid £2.2bn last year, albeit down from £3.4bn the prior year.

The company commented in February that “investment in value-enhancing acquisitions will be considered where market conditions are right and where they deliver on the Group’s strategy.” With the defence market seemingly on a tentative uptrend, BAE Systems could be tempted to enter the acquisition fray once again.

Growth expected to resume next year

City brokers expect BAE Systems to follows years of fluctuating earnings with a 5% earnings dip in during 2014. But the defence specialist is anticipated to punch a modest 3% rebound in 2015 amid an improving sales outlook.

Although the firm’s earnings prospects could be considered underwhelming during this period, at current share prices BAE Systems deals on a P/E multiple of 10.3 for 2014, representing a significant discount to a forward average of 14.2 for the complete aerospace and defence sector.

And for long-term investors, I believe that the company’s diversified — and in many cases market-leading — operations across a multitude of defence sub-sectors should maintain its top-tier supplier status with the likes of the US and the UK well into the future.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Royston does not own shares in BAE Systems.

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