It’s a defensive stock but it’s not a defensive play. BAE Systems (LSE: BA) (NASDAQOTH: BAESY) relies on big contracts to push its bottom line along. Fortunately the company is good at what it does, so investors can rest easy. In fact, I want to argue that it’s a sound investment for the long term.
Before I get into the numbers — and if you like big toys — I urge you to look into some of the aircraft that BAE Systems is developing. Just a couple of examples include aircraft that, once threatened in the air, can split apart and act independently; or, one of my personal favourites, materials that will enable aircraft to heal themselves mid-flight. What an amazing research and development department this company must have. It conjures up images of ‘Q’ working away in a lab in a 007 movie.
Let’s get the bad news out of the way
BAE warned in February that earnings would fall by up to 10% this year because of US defence spending cuts and the non-recurring benefit from the settlement of the Salam deal with Saudi Arabia. It was also hit by an impairment charge of £70 million against its South African Land Systems business. And again in the US, it said it would take a £30 million charge from its commercial ship building programmes.
That all helps to explain why, year on year, BAE’s net income fell 82% despite relatively flat revenues. Encouragingly, the company managed to boost its profit margin in the second quarter of this year.
Another difficult area of this company to reconcile is its valuation. BAE’s price earnings multiple is currently sitting at 89. Having said that, the defence company’s average earnings per share growth is ranked in line with its peers.
The good news
BAE Systems has won a £600 million contract that will see it manage Portsmouth Naval Base (including the management and support of half of the Navy’s fleet) for the next five years.
The company also took £7.9 billion worth or orders in the first three quarters of this year. Importantly, for a strategic point of view, a third of those orders came from outside the US and the UK. As an added bonus, management reported last month that its bullish on its business in the Middle East.
I’m not so sure if this is a company for those nervous nellies out there. It’s light-on in terms of cash, and its earnings, over the long- term, are uncertain. It does, however, offer an attractive income proposition: dividend growth over the year was 3%, now yielding around 4%. In addition, its five-year dividend growth rate is close to 7%.
The bottom line
I suspect BAE investors who are only in it for the short run will have a bit of a white-knuckled ride for the remainder of this year. For longer-term investors, I see a brighter future. Not only is the company more than satisfactory from an income play point of view, but I can’t see ‘world peace’ dominating the news headlines any time soon if you catch my drift. In that sense, if BAE Systems remains credibly solvent, I suspect its dominant market position will continue to benefit the company well into the future.
I concede, however, that this certainly isn’t a stock for everyone.
