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Why BAE Systems plc shares look great value while the Footsie is down

The aerospace and defence business has been through a few tough years, and I’ve seen that as especially disappointing as it includes a number of British engineering firms that really are world class. Even the venerable and excellent Rolls-Royce Holding hit a very rare sticky patch.

But better times appear to be upon us, and I see the sector as becoming more attractive. I’m particularly drawn to BAE Systems (LSE: BA), whose full-year results on Thursday show seriously improving health.

Sales came in largely flat — actually up £0.6bn to £19.6bn, but that was mainly down to currency movements. But underlying EBITDA gained 4% at constant currency to £2,034m, with underlying earnings per share up 8% to 43.5p.

Liquidity figures look heartening too, with operating business cash flow up £748m to £1,752m, and the firm’s net debt has been cut by £790m since the end of December and now stands at just £752m. There’s a pension fund deficit that’s causing concern, but that’s moving in the right direction too, as the group’s share of it was down £2.2bn over the year to £3.9bn.

The only disappointment was a reported drop in operating profit to £1,480m, partly due to a “non-cash goodwill impairment in Applied Intelligence reflecting lower growth assumptions” of £384m. That shook the share price a little, which fell 2% in morning trading to 587p.

Tempting dividend

The full-year dividend was lifted by a modest 2% to 21.8p, to provide a pretty decent yield of 3.6%. That’s twice covered by earnings, and I see it as a very satisfactory at this stage.

The current year is expected to be flat, but I’m happy to see £20.3bn in order intake during 2017 which left BAE’s order backlog standing at £41.2bn. That provides better visibility than a lot of companies can offer, and further EPS growth indicated for 2019 looks eminently plausible.

On a forward P/E of 13.6 for 2018, dropping to 13.1 by 2019, I see BAE shares as good value now, especially with such attractive progressive dividends. 

I see the sector as one that’s returning to health, but cautious markets have not yet caught up with it — and that lag could mean bargains for canny investors.

Footsie cheap?

The FTSE 100 as a whole is under pressure this week, as the UK’s latest unemployment figures from the Office for National Statistics (ONS) showed an unexpected rise. With the number out of work up 46,000 in the three months to December, the jobless total currently stands at 1.47 million.

On top of that, wage rises are still lagging behind inflation, leading to a 0.3% fall in workers’ incomes in real terms. But the figure, with basic earnings up 2.5% for the year, was better than expected. 

And the ONS also revealed the strongest two quarters of productivity growth since 2008, with output per hour up 0.8% in the December quarter, on top of a 0.9% rise in the preceding three months.

Uncertainty is the big problem, coupled with a cautious response to the FTSE 100’s gains of the past two years which raise fears of overheating.

But it’s looking genuinely undervalued to me, having lagged the FTSE 250 over five years — it’s up a mere 13% since February 2013, while the index of smaller companies has climbed 44%. And the top index’s forward dividend yield is getting close to 4.5%, which is well ahead of its long-term trend.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.