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Is the BAE Systems share price heading for 500p?

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In a market correction, good companies often get caught up in the general sell-off. This can be a great buying opportunity for savvy investors.

I’m going to start this piece by looking at FTSE 100 defence giant BAE Systems (LSE: BA). The group’s share price is down by about 13% from its 52-week high of 680p. But despite the market sell-off, BAE shares are still up 3% this year, compared to a 7% drop for the FTSE.

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Keep calm and carry on

I’ve said many times before that I view BAE Systems as a good long-term income stock.

The size and diversity of its business means that it should be able to adapt to changing requirements and new technology. And although its cash flow can be lumpy (depending on contract timings), over a 5-to-10-year timeframe this business tends to generate quite a lot of surplus cash.

Chief executive Charles Woodburn says that 2018 will be a “transition earnings year.” Adjusted earnings are expected to be broadly flat, but recent contract wins bode well for future growth, as my colleague Royston Wild recently explained.

Into the buy zone?

At current levels, BAE trades on a 2018 forecast P/E of 13.7, with a prospective yield of 3.8%. I think this is a fair price for long-term buyers, but given the trend towards rising interest rates and higher bond yields, I think there’s a chance the shares will keep on falling.

At 550p, the shares would yield about 4%. At 500p, the dividend yield would rise to 4.5%. I think there’s a chance that the stock will get down to 550p, if not a little lower. At that level, I’d be a buyer.

A tricky situation

One stock in my own portfolio that’s been hit hard today is geotechnical specialist Keller Group (LSE: KLR), which is down more than 25% following a profit warning.

Keller is the world’s largest groundworks contractor. It’s a highly specialist business, working on construction projects such as oil refineries, major tunnels and skyscrapers.

Today’s profit warning has been triggered by problems in the group’s Asia-Pacific (APAC) business. Operations in this region were loss-making last year, but were expected to return to profit this year. The company says market conditions have deteriorated in this region, especially in Malaysia.

But there’s also a second problem — a change of management has led to “the reassessment of project performance.” My reading of this is that new managers in the region are taking a more realistic view of underperforming projects and have flagged up new losses.

What’s the damage?

Keller says that its APAC division is now expected to report a pre-tax loss of £12m-£15m this year.

Underlying pre-tax profit last year was £98.7m. Before today, analysts’ forecasts suggested a fairly flat performance this year. So this profit warning seems to suggest that earnings could be around 15% lower than expected this year.

The shares have fallen much further than this and are down by 27% at the time of writing. I estimate this slump puts the stock on a forecast P/E of 8.2, with a prospective yield of 5.1%.

That could be cheap, if the group’s core US and EMEA markets remain strong. The risk is that there could be more bad news to come. I wouldn’t buy at this level until we know more.

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Roland Head owns shares of Keller Group. 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.

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