MENU

Is Meggitt plc A Better Buy Than BAE Systems plc Or Cobham plc?

Shares in aerospace and defence firm Meggitt (LSE: MGGT) rose by more than 6% when markets opened this morning, after the company issued a cautiously optimistic interim update, and said that it would begin a share buyback programme.

Meggitt shares have fallen steadily this year, thanks to a weak outlook and the firm’s August profit warning, but today’s news suggests management are confident that they will be able to avoid any further cuts to guidance.

Given this, I’m asking whether Meggitt is now a buy — and whether it is more attractive than UK peers BAE Systems (LSE: BA) and Cobham (LSE: COB)?

Buyback news

Meggitt says it has decided to buy back some of its shares because it cannot find any suitable acquisitions and has a strong balance sheet, which is backed by a recent refinancing deal that’s provided the firm with a five-year, $900m credit facility.

However, Meggitt’s apparent plan to fund the repurchases with debt in order increase its ratio of net debt to EBITDA to a target level of 1.5 concerns me. Using debt to fund buybacks is often a short-term measure to boost earnings per share, rather than a genuine return of surplus cash to shareholders.

By increasing debt at a time of slow earnings growth, Meggitt is gambling on future growth cancelling out the increase in debt.

Superior profitability

Having said that, Meggitt can claim with some justification to be a strong financial performer, as these figures show:

 

Meggitt

BAE Systems

Cobham

Operating margin

17.6%

4.6%

8.9%

5 yr. average revenue growth rate

+7.3%

-3.6%

-1.0%

5 yr. average underlying earnings per share growth

+7.3%

+1.4%

+2.8%

Source: Company reports

Meggitt’s superior profitability supports the firm’s argument that it can operate efficiently with a higher level of debt than at present, and its current valuation, relative to BAE and Cobham, looks reasonable, although not cheap:

 

Meggitt

BAE Systems

Cobham

2014 forecast P/E

14.4

12.1

14.4

2014 prospective yield

2.9%

4.5%

3.7%

Source: Consensus forecasts

Is Meggitt the best buy?

Meggitt’s dividend yield is below the FTSE 100 average and at 2.9%, is much lower than either BAE or Cobham. For a potential investor, this lower near-term yield needs to be offset by superior capital gains, or by more rapid dividend growth than the other two firms can provide.

Meggitt certainly has a more impressive growth record than Cobham, but the difference appears to be closing, with both firms expected to deliver earnings per share growth of around 10% in 2015, along with dividend growth of 8%-9%.

Overall, I believe all three shares are reasonable, but not outstanding buys: the potential for further earnings downgrades remains a risk for all three, in my view.

My pick, in today’s market, would be Meggitt, thanks to its fatter profit margins, although I do have some reservations about its buyback policy.

Better buys elsewhere?

Of course, you may not agree with my verdict. However, regardless of your opinion, I urge you to take a look at "7 Simple Steps For Seeking Serious Wealth".

The Motley Fool's market-beating analysts have produced this exclusive new wealth report to share a simple 7-step process that could help you become one of the UK's growing number of secret millionaires.

This report is FREE and without obligation, but availability is limited -- to receive your copy immediately, click here now.

Roland Head owns shares in BAE Systems. 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.