Over the past year the share price of BAE Systems (LSE: BA) has hardly moved even as the defence giant has made good progress in increasing cash flow, repairing its balance sheet and is set to benefit from 2018 global spending on defence programmes to hit a post-Cold War high. This makes me believe BAE could be the best bargain in the FTSE 100 at its current valuation of only 14 times forward earnings.
Over the short term, the name of the game for BAE is cash flow improvements as the company retrenches following several years of trimmed defence budgets in the West while it waits for increased spending from the likes of the US to flow through into its income statement. That can take a while due to procurement processes. Last year the company met with considerable success in this area as its operating business cash flow rose over 70% from £1,004m to £1,752m even as sales only rose by 3.1% to £19,626m.
As new orders begin to roll in from increased defence budgets in the US, Europe and the Middle East, more streamlined operations will be hugely beneficial for margins and cash flow. This is good news both for earnings and for the group’s already considerable dividend that yields a solid 3.55% annually.
This is especially true as the balance sheet is in increasingly good health, which should help management boost shareholder payouts. At year-end, the group’s net debt position had fallen to £752m from £1,542m year-on-year while its pension deficit decreased from £6,100m to £3,900m.
With global defence spending due to rise by over 3.3% in 2018 according to IHS Jane’s, BAE is in a great position. And with increased focus on cash flow already paying off, I see good scope for management to boost profits ahead of revenue over the medium term. Add in a hearty dividend yield and this leads me to believe BAE is a bargain at its current valuation.
Early signs of a turnaround
This is in stark contrast to fellow defence contractor Cobham (LSE: COB), which is still recovering from a years-long acquisition binge that the new management team is currently struggling to unwind.
The company’s AGM trading update released this morning showed the group is making progress, but there remain several significant issues still facing the company. Chief among these has been repairing the heavily-indebted balance sheet. Progress has been made, with a £500m rights issue last year as well as the recent sale of its test and measurements business for $455m. These moves have staved off fears of breaching debt covenants.
However, management warned this morning that operational improvements will take longer to fix and that it expects “limited cash generation in 2018.” This is hardly a surprise given management had previously warned as much, but investors hoping for a quick turnaround will need to be more patient.
For now it appears Cobham’s new CEO is making good progress on cutting unprofitable contracts, streamlining operations and repairing the balance sheet. If he can pull this off while also profiting from rising defence budgets, Cobham could yet be an interesting turnaround. But for now there are too many question marks for me to invest in a company with a long track record of poor performance.
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Ian Pierce 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.