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FTSE 100 defence giant BAE Systems (LSE: BA) is a popular choice with income investors. But it’s a big business that’s unlikely to double or triple in size again. Are shareholders missing out on long-term growth opportunities at medium-sized defence firms?

Today, I want to take a fresh look at BAE and consider a more specialist alternative, Chemring Group (LSE: CHG). This £440m firm specialises in missile countermeasures and sensor-based protection systems.

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A solid turnaround?

Chemring has been through a difficult few years. The group reported annual losses from 2013 until 2015 and raised £81m of fresh cash in a rights issue in 2016. Last year, the firm’s Salisbury factory was forced to close after a tragic incident that cost the life of one employee.

However, debt levels are now under control and the firm’s profitability has started to improve. Final results published on Thursday suggest continued progress. Although sales from continuing operations fell 3% to £297m last year, underlying pre-tax profit rose by 25% to £25m. As a result, the group declared a dividend of 3.3p, 10% higher than in 2017.

Reassuringly, Chemring’s net debt was largely unchanged last year. My analysis of the firm’s cash flow suggests that its operations are now generating enough cash to support the dividend and fund some investment in growth.

Buy, sell or hold?

The outlook for 2019 also seems encouraging. That Salisbury factory is expected to gradually reopen, boosting earnings, which City forecasts suggest will rise by 66% to 11.5p per share.

However, sales are expected to fall again this year. This suggests that rising profits represent recovery, rather than growth. On that basis, the stock’s forecast P/E of 13.7, and dividend yield of 2.4%, don’t seem that cheap to me. I won’t be buying.

BAE has done better

While Chemring has been struggling in recent years, BAE Systems has been quietly plodding ahead. The group’s critics sometimes suggest that it’s unlikely to deliver much growth, but the facts suggest otherwise.

The BAE share price has risen by 15% over the last five years. That puts it significantly ahead of Chemring (-30%) and the FTSE 100 index itself (+4%).

I’ve written before about the attractions of this diverse group. BAE’s portfolio includes ship-building, military jet aircraft, vehicles, weaponry, electronics and cyber warfare. Although revenues in some areas can be lumpy and vary from year to year, over longer periods this group is proven to be a profitable and cash generative business.

Strong cash generation is reflected in BAE’s dividend history. The shareholder payout hasn’t been cut for 20 years and has risen by 51% over the last 10 years.

A safe Brexit buy?

BAE’s customers are mostly located in the UK, USA and Middle East. So Brexit seems unlikely to have a direct effect on these relationships. There could be a risk to joint ventures with major European companies but, in my view, this is the kind of problem that tends to get sorted out in the background.

I see this FTSE 100 giant as a very solid buy for income and long-term growth. Trading on 11 times 2018 forecast earnings, and with a 4.4% dividend yield, the shares look decent value to me. I’d buy.

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And if you click here, we’ll show you something that could be key to unlocking 5G’s full potential...

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Roland Head 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.

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