Shares in the UK’s largest defence company, BAE Systems (LSE: BA), rose 5% excluding dividends in September.
According to my research, investors rushed to buy the stock following an earnings upgrade from City analysts.
Analysts have been steadily increasing their outlook for the business over the past few months, following a handful of positive trading updates.
Growing business
City analysts now expect the company to earn around 45.4p per share for 2019, up from 44p in July. These upgrades mean that the group’s earnings per share are on track to grow approximately 28% in 2019.
If BAE can meet this forecast, then I think the stock looks cheap at current levels. At the time of writing, shares in the business are currently dealing at a forward price-to-earnings of just 12.1, below the five-year average of around 15.
As well as the company’s growth and attractive valuation, the stock also supports a dividend yield of 4.2%. This is one of the most attractive dividend yields in the FTSE 100 because the payout to shareholders is covered nearly twice by earnings per share.
Putting all of the above together leads me to the conclusion that even though the BAE share price rose 5% in September, and is up around 20% since the end of May excluding dividends, it is still an attractive investment.
Booming market
As the largest defence company in the UK and one of the largest in the world, BAE has a virtually guaranteed income stream from governments who want to buy its equipment.
On top of this, the company owns a lot of intellectual property and has a burgeoning cyber defence business. This division is expected to be a key area of growth for the group over the next few decades.
The company won a string of contracts in September, including a $2.7bn US defence contract for the production of the Advanced Precision Kill Weapon System.
In the first half of the year, the group agreed on £8.4bn of deals with third parties, taking its total order backlog to £47.4bn, up 19% year over year and locking in around three years of revenues.
Undervalued
Generally, companies with a high level of revenue visibility, like BAE, deserve high valuations. For some reason, the market has decided that this does not apply to the firm at the current time. I think this could be a great opportunity.
With three years of revenues guaranteed and earnings per share expected to jump by 28% in 2019, BAE looks to me to be a steal.
In addition to its low valuation, investors are on track to receive a dividend yield of 4.2% this year. That only adds to the appeal of the stock, in my opinion. Management is targeting £3bn of free cash flow over the 2019–21 period, which should be enough to both grow the business and maintain its current level of distribution to shareholders.
