I hold BAE Systems (LSE: BA) shares in my Self-Invested Personal Pension (SIPP) but I have mixed feelings about their recent success. They’re 29% over the last year and an astonishing 230% across five years. As a weapons maker, much of the demand has come Western concerns about war in Ukraine and broader tensions with China.
The same applies to another FTSE 100 defence firm, Babcock International (LSE: BAB), which I don’t hold. The Babcock share price has rocketed 84% in the last year. Over five, it’s up 255%.
BAE is the giant, worth more than £50bn, while Babcock sits just above £5bn. Being the smaller player has made it more nimble in recent months.
There’s talk of a possible, much-desired, peace agreement in Ukraine, and a huge degree of scepticism about the outcome, particularly in Europe. That may have an impact on share prices in the short-term, but the long-term case for defence stocks remains strong, in my view. Sadly, we live in an certain world, and the peace dividend following the fall of the Berlin wall in 1989 has long been spent.
FTSE 100 defence giant
A bigger concern is that both valuations are starting to look stretched after their recent strong run, especially at BAE, which trades on a price-to-earnings ratio of 25.7. That’s way above the FTSE 100 average of around 15 times. Babcock looks cheaper at 19.8 times, despite its faster recent growth.
The orders are rolling in. On 30 July, BAE Systems posted an 11% jump in half-year sales to £14.6bn and a 13% rise in operating profit to £1.6bn. It also upgraded full-year guidance while the order book sits at a massive £75.4bn.
BAE’s yield may look modest at 1.83%, but that’s mostly down to the share price surge. Dividends have been rising by around 8% a year.
Babcock’s results on 25 June were equally striking. Operating profit jumped 50% to £364m, and it announced its first ever £200m share buyback. The order backlog rose to £10.4bn.
Politics and profits
NATO members are being pressed to lift budgets towards 5% of GDP, with the UK pledging 2.6% from 2027. Babcock is now the Ministry of Defence’s second-largest supplier. BAE Systems is first.
Ethical investors will want to avoid this sector but for others, it’s underpinned by governments keen to prioritise national security. The big question is whether European governments have the will or the money to commit to their defence spending promises. And some defence spend is also shifting from costly, large scale weaponry to cheap and nimble drones, and that could affect the type of kit these two make, and how much they earn from it. They’ll have to adapt.
What do the experts say? Consensus forecasts suggest the BAE Systems share price could hit 2,116p over the next year, up 17.5% from today’s 1,800p. Babcock shares are forecast to hit 1,203p, up 16.5% from today’s 1,033p. Predictions must always be taken with a pinch of salt but these are broadly what I expected to see.
My take is that both companies look pricey, but the order pipelines and policy backdrop suggest they are still well worth considering with a long-term view. Even at today’s high prices.
