What Are The Prospects for BAE Systems plc Following Profit Warnings From Meggitt plc and Chemring Group plc?

This Fool dons his tin hat to assess the potential for profit downgrades at BAE Systems plc (LON: BA) after warnings from Meggitt plc (LON: MGGT) and Chemring Group plc (LON: CHG)

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Whilst the market has spent the last three months worrying about the slowdown in China and the wider global economy, investors may have missed the more company-specific news. Indeed, there have been plenty of profit warnings from companies failing to live up to market expectations. As one would expect, the ir shares have been dumped in the market as investors headed for the exit.

As you can see from the chart below two such companies, Chemring (LSE: CHG) and Meggitt (LSE: MGGT), have seen a significant decline in their share price following disappointing trading statements last week. It appears that there has been some ‘read across’ to the share price of BAE Systems (LSE: BA) whose shares seem to have fallen in sympathy. The question for me now is whether this presents an opportunity or means that a degree of caution is required? Let’s take a look…

Serial disappointer?

As an investor, I remember a fair number of profit warnings from Chemring, starting in 2012. It seemed that this was mainly due to the US curtailing expenditure following budget cuts and delayed contracts to the Middle East. Add to that the failure to sell itself to private equity outfit Carlyle, and the stock was firmly on my ‘shares to avoid’ list.

However, fast forward to 2015, in particular 14 September. Management updated the market with an ‘in line’ trading statement. Revenue in the four month period to 31 August 2015 was £119.0m, an increase of 23.8% compared with £96.1m in the same period last year, and the order book at 31 August 2015 was £592.1m, 17.8% higher than the order book of £502.8m at 30 April 2015. This increase resulted from the receipt of orders in excess of £100.0m relating to the supply of 40mm ammunition to the Middle East.

Then on 26 October, the group warned that there was potential for delay to revenues from the 40mm ammunition contract announced on 14 September 2015, and as a result of that and other issues, there was now a realistic prospect that year ending 31 October 2015 underlying operating profit could be reduced by approximately £16m to approximately £33m.

Additionally, management was in discussions with debt providers to negotiate amendments to the operation of covenants and a proposed rights issue of up to £90m in Q1 2016, fully underwritten on a standby basis.

Ongoing weakness

Then last Wednesday sector peer Meggitt disappointed the market. Management stated that trading during the third quarter was below expectations, due to a marked deterioration in September. Continued organic growth (excluding the effects of M&A and foreign exchange) of 2% in civil original equipment was more than offset by weaker than expected trading in civil after-market (0%), military (-2%) and energy (-16%) markets, resulting in an organic decline of 1% in the quarter.   

Furthermore, profitability in the third quarter had been impacted by mix, both across end markets and within the after-market, following lower than anticipated spares volumes for older civil and military aircraft. Additionally, lower volumes and a number of programme deferrals announced by customers had also impacted margins.  Energy markets continued to weaken, with the further organic decline resulting in lower than expected overhead absorption. The trend was expected to extend into the fourth quarter, resulting in underlying operating profit for the year being “meaningfully below” the current consensus estimate of £369m.

As expected, the shares took a bath and finished the week off by nearly 27%, meaning they’re now down 32% in the year to date.

A sign of things to come?

As I’ve noted above, there seemed to be a degree of ‘read across’ resulting in the decline of BAEs shares. The only piece of news from the company was the release of the date of the final results scheduled for February 2016. For now it would appear that it is business as usual, and results are in line with expectations. If they were not then management would need to advise the market, as we have seen with Chemring and Meggitt.

In effect, all investors have to go on is the guidance issued at the interim stage. Management steered investors to an anticipated H2 weighted result. They confirmed that the Group remained on track to deliver sales growth and continued to expect underlying EPS for 2015 to be marginally higher than in 2014, despite the lack of earnings accretion from share repurchases. The guidance was conditional upon anticipated aircraft orders and a review of options for the Melbourne shipyard facility, and assumed an average exchange rate of $1.55/£.

This Fools final thought….

As things stand there is no evidence that BAE is trading below expectations. Additionally, the issues at Meggitt and Chemring seem broadly company specific.

And until investors hear otherwise, in my view they should focus on BAE — a sizable FTSE 100 company with a sizable order book that’s trading on 11 times forecast earnings and yielding a market beating 4.9%.

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.

Dave Sullivan has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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