The BAE Systems (LSE: BA) share price has soared 65% in the last year, but in the defence sector that almost marks it down as a slowcoach.
Shares in smaller FTSE 100 sector peer Babcock International Group (LSE: BAB) have rocketed 118% over the same period. Over five years, BAE and Babcock are up 322% and 411% respectively. Yet Rolls-Royce Holdings (LSE: RR) still leaves them both in the shade.
Rolls has shot the lights out, rising 116% over one year and an astonishing 1,070% over five, the biggest winner on the entire blue-chip index. Of course, it’s far more than a defence contractor. Rolls-Royce makes aircraft engines, has a thriving Power Systems division benefiting from AI data centre demand, and a potentially huge opportunity in small modular nuclear reactors.
Flying FTSE 100 sector
Across the FTSE 250, smaller defence players such as Chemring, Goodwin, and QinetiQ are also going great guns. The sad truth is that investors are responding to rising geopolitical tensions. Russia and Ukraine remain locked in conflict. The US and Iran are close to confrontation. China is a huge worry. Germany is planning to pump €500bn into arms, and other European states are being pushed to up their spending. In the UK, there’s talk of a £28bn defence ‘black hole’.
It would be brave to bet against defence stocks today. But after such a blistering run, valuations look stretched. Expectations are high, and even a small earnings miss could be punished.
Typhoon fighter jet and warship maker BAE Systems trades on a hefty price-to-earnings (P/E) ratio of 28.5. However, full-year results on 18 February help justify it. Underlying operating profit rose 12% to £3.32bn, beating forecasts. The order backlog hit a record £83.6bn, while net debt fell 22% to £3.84bn.
Babcock is scarcely cheaper, with a P/E of 27.9. First-half results (21 November) showed underlying operating profit up 19% to £201m, and its contract backlog rising to £9.9bn. Rolls-Royce delivers full-year results tomorrow (26 February). Keep an eye out for those — everybody else is. I’ll just say that its trailing P/E stands at a dizzying 65.
Brokers consensus forecasts
So where do brokers think the shares go next? Seventeen analysts offering 12-month forecasts for BAE Systems produce a consensus target of 2,237p. That implies a modest rise of just 5.35% from today.
Nine analysts covering Babcock are slightly more upbeat, with a consensus target of 1,547p, around 11% higher. Sixteen analysts follow Rolls-Royce, but their median target of 1,333p suggests gains of just 2%.
Of course, broker forecasts are educated guesses and often include stale assumptions. These low targets may surprise some, but show the air is getting thin at these valuations. Also, European economies are struggling, there’s a limit to how much politicians can spend on defence, or are willing to spend.
Babcock and BAE Systems remain worth considering for the long-term but after such extraordinary gains, the short term could prove bumpy. Rolls-Royce ratchets up the risk level and I personally wouldn’t consider it at today’s dizzying P/E (I may regret saying this tomorrow). If any of them dip, that might offer a better opportunity. But personally, I’m on the hunt for the next fired-up FTSE 100 growth story instead.
