Over the past 12 months, the BAE Systems (LSE: BA) share price has gone off the boil. The stock has declined from a high of around 675p, printed at the end of July 2018, to 500p at the time of writing. At one point late last year, the stock was dealing below 450p, its lowest level since the end of 2015.
These declines have been bad news for existing holders, but great news for investors who are looking to buy into this global UK champion at an attractive valuation. Indeed, at the time of writing, shares in the defence giant are changing hands at a forward P/E ratio of just 11.1 and support a dividend ratio of 4.6%.
According to my research, this is the lowest valuation the shares have attracted in almost five years. Historically, the stock has changed hands for between 15 and 20 times earnings. So, on this basis, shares in BAE Systems now look undervalued. The question is why?
Well, it looks to me as if the main reason why investors have moved away is BAE’s association with Saudi Arabia where it’s the lead industrial partner for the pan-European Eurofighter consortium. It’s responsible for the maintenance and support of its 72 typhoon jets, including the supply of parts, which is worth around £2.5bn to the company. On top of this, last year it signed a memorandum of understanding with the Kingdom for another 48 jets worth an estimated £5bn to BAE.
The decision by policymakers in Germany to stop the export of weapons to Saudi Arabia in the wake of the murder of journalist Jamal Khashoggi has threatened to destabilise this deal as Germany is one of the four countries in the European consortium. This work is worth an estimated 15% of BAE’s annual earnings, and the recent share price decline seems to reflect this.
If the deal with Saudi Arabia does fall through, it will be a big hit for the enterprise. However, BAE isn’t a one-trick pony. Last year, the company reported an £8bn surge in orders to £28.3bn in the 12 months to the end of December 2018, boosting its overall backlog to £48.4bn. This growth suggests to me that no matter what happens with Saudi Arabia, BAE’s long-term outlook is bright.
Losing its business with Saudi Arabia might hit earnings in the near term, but the company has plenty of other group initiatives.
For example, management is planning to double the size of the group’s Australian business over the next five years. It’s also talking with potential partners about the UK’s plans for a next-generation fighter jet and management is also lining up potential acquisitions in the world’s largest defence market, the United States.
The bottom line
Overall, while Germany’s decision to stop arms sales to Saudi Arabia might have cast a shadow over BAE’s deals with the Kingdom, I believe that the group’s long-term outlook remains robust.
Investors could be well rewarded by taking advantage of the current uncertainty to snap up shares in this global defence giant at what looks to be an extremely attractive valuation.
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Rupert Hargreaves owns no share 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.