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Why I’d Rather Buy BAE Systems plc Instead Of BT Group plc

Over the course of the last year, shares in BAE (LSE: BA) (NASDAQOTH: BAESY.US) and BT (LSE: BT.A) (NYSE: BT.US) have easily outperformed the FTSE 100. Of course, that’s not too difficult when the FTSE 100 is flat during the period, but BAE’s performance in particular is worthy of note, since it has gained 19% in the last twelve months versus a rise of 11% in BT’s valuation.

Looking ahead, I believe that BAE will continue to outperform BT, which is why I’d rather buy the former than the latter at the present time.

Future Potential

The defence industry has endured a challenging time in recent years. Spending cuts across the developed world and, in particular, US sequestration, have hurt demand for BAE’s products, which led to a fall in the company’s bottom line of 10% last year. And, while demand from emerging economies is on the up, it is not yet sufficient to make up for the reduced order numbers from the nations that traditionally spend big on defence items.

However, the improving outlook for the developed world means that BAE is set to increase its bottom line by 2% this year, and by a further 6% next year. Admittedly, these numbers are not particularly astounding. After all, the FTSE 100 is expected to post a gain in the mid to high single digits during the period. But it shows that, from 2016, BAE should be able to match the wider index growth rate. As such, there is tremendous scope for an upward rerating to its valuation, with its price to earnings (P/E) ratio of 13 being low compared to the FTSE 100’s P/E ratio of around 16.

Future Challenges

For BT, the present time is one of great excitement. It is moving into quad-play (broadband, landline, pay-tv and mobile from one supplier) and could, in time, dominate the market. That’s especially the case since BT seems to be very willing to invest in the rights to top sports coverage, which history has shown is a tremendous pull for customers.

However, BT faces stiff competition from a number of companies who are also muscling in on the quad-play market. The challenge is that its rivals have huge financial firepower, with the likes of Vodafone and Sky having strong balance sheets, excellent cash flow and deep pockets. As such, a period of margin suppression could ensue, as all three companies seek to win new customers at the expense of profitability.

In fact, BT is expected to see its profit fall by 3% in the current year and, while its shares do trade at a discount to the wider index on a P/E ratio of 14.5, BAE’s valuation is far more attractive and its present performance more appealing.

Looking Ahead

Of course, BT remains a sound ‘buy’ at the present time and, while it faces stiff competition, it has the finances, strategy and products to overcome this threat and become a major player in the quad-play market.

However, when it comes to future share price performance, BAE’s industry is on the up, with demand set to increase. This should serve as a catalyst for a share price that, while having performed well in the last year, still has a long way to go. Therefore, for me, BAE is the more enticing stock to buy right now.

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Peter Stephens owns shares of BAE Systems. The Motley Fool UK has recommended Sky. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.