Britain's largest defence company's new strategy is de-risking the business.
Increased NATO defence spending is low-hanging fruit for BAE Systems.
The company's dividend track record and strong financials are underappreciated in the stock's undemanding valuation.
A truly defensive holding, in both senses of the meaning, for any portfolio.
BAE Systems (OTCPK:BAESF) is a group delivering, through its wholly owned subsidiaries and equity accounted investments, a full range of products and services for air, land, and naval forces, as well as, advanced electronics, security, information technology solutions and customer support services.
In the aftermath of the Jamal Khashoggi killing in October 2018, Britain's largest defence company BAE Systems stock price fell 27% as sentiment towards anything related to Saudi Arabia soured fast. Since then, the stock has recovered but is still trading below its September 2018 levels.
The world has moved on from Saudi Arabia, and as the gold price has been showing recently, thanks to the Iran-US tensions, the geopolitical risk has risen and the outlook for defence stocks is positive again.
Even before the recent Iran tensions, fundamentals for BAE Systems have been improving in recent months. The company is reducing its dependence on riskier markets, a Conservative victory in Britain’s government removes the risk of an anti-war cheerleader in Jeremy Corbyn, and NATO has agreed to spend more on defence after many years of austerity in that department.
Conservatives’ general election victory
Unlike many companies important to the UK’s domestic infrastructure, BAE was not a specific nationalisation target for Jeremy Corbyn’s Labour Party. The risk was around the fear that as a well-known pacifist, Jeremy Corbyn, might reverse plans for Britain to renew its nuclear deterrent.
BAE would have directly suffered, as it makes the submarines that carry the UK’s Trident nuclear missiles. Additionally, Corbyn’s government was likely to put greater scrutiny on the company’s exports: such as maritime products, and an array of air, cyber and land-based military assets which BAE sells across the world’s major defence markets. With the Conservative victory, the company has a green light to continue under free market conditions.
BAE’s biggest market is America, which, as the world’s biggest spender on defence, accounts for 42% of the company’s revenue. Following a long series of cuts under President Obama, the US increased military spending by 7% in 2018, its fastest rate of growth in a decade. With President Trump sending troops to the Middle East, and with the election on the horizon, we can’t be surprised if this number grows even faster in 2020.
President Trump has also pressured NATO allies to also increase their spending on defence. After years of fiscal consolidation in Europe, austerity is gradually being eased and the alliance’s members have agreed to more quickly move to the target of spending 2% of their GDP on defence by 2024. In 2019, only nine of the 29 members met the 2% of GDP target.
Markets such as France, Germany, and Italy are important to BAE, and so, this political commitment is expected to provide a prolonged tailwind for the company’s sales as NATO members look to meet their membership military spending obligations.
The Global Investor has the view that the defence industry’s growth prospects will also be supported by an improving outlook for the world economy. Global growth is expected to be 0.4 percentage points higher in 2020 than last year, according to the IMF. As economies grow, tax receipts grow, and BAE’s client base is predominately world governments.
Increasingly diversified sales base
While Brexit-related risks potentially have the capacity to slow economic growth in the UK and European Union this year, BAE’s modest level of sales with EU nations does limit this risk. This lower level of European exposure provides a useful hedge to UK and European investors worried that the prospect of a no-deal Brexit at the end of the transition period is still currently a possibility.
Management has stated the group is ramping up production as it seeks to execute on a record order backlog that grew by 25% in 2018. A trading update in November 2019 highlighted the group’s success in winning new contracts across a wide range of markets. The group’s 2018 organisational restructuring, which included senior management changes, is also beginning to bear fruit as efficiency and competitiveness are improving.
BAE has known that investors do not like its high exposure to the Middle East and the US, and has sought to diversify the range of markets in which it operates. Saudi Arabia, for example, which accounted for 14% of the company’s revenue last financial year, is faced with sanctions now - a growing geopolitical weapon; thus, physical weapon sales could be hit at a moment’s notice. Therefore, BAE’s focus on being less geographically focused makes sense. One good example of this increased global focus is the company's Australian business, where management has stated it expects revenues to double over the next five years following the award of a contract in 2018 for the design and construction of nine ships.
The Global Investor views the threat of sanctions by US or Europe on Middle Eastern countries has been responsible for the stock’s lacklustre performance over the last three years. Despite the stock’s 33% rally since May 2019, it still trades at a very undemanding EV/EBITDA of 10.4. The company's Return on Equity is a tidy 19.3%, and a dividend yield of 3.9% looks safe. Dividends have risen in each of the past 15 financial years, demonstrating management’s commitment to continued profit and dividend growth. The stock trades at a P/E ratio of just 13.5 and has a decent cash conversion ratio of 81%, reflecting the AAA nature of many of its government client base.
Financial performance should be driven by rising demand for BAE’s products and services. The company’s long history, advanced engineering capability, and strong reputation in defence departments across the world gives it a competitive advantage across its product range. The Global Investor expects the company order book to increase at a healthy rate as NATO and other countries see renewed defence spending. The Conservative Party’s “Global Britain” agenda and new trade deals set to be signed in the coming years will also help reduce trade frictions for BAE’s exports.
The general election result also avoids a significant change to Britain’s own defence policy. While the “Boris Bounce” has included BAE so far, the company’s new lower-risk strategy, coupled with macro tailwinds, means this quality defensive stock deserves a much higher rating.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BAESF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.