3 Reasons Why You Should Consider Buying BAE Systems (OTCMKTS:BAESF)

This year has been rather disappointing for shareholders in British-based defense firm BAE Systems (OTCPK:BAESY). Year to date, the stock has lost nearly 17% of its value, despite resilient growth in its order intake during the first half of 2020.

Looking ahead, however, there are three key reasons investors should consider buying BAE Systems.

1. Defense Spending Provides Stability

The defense sector is traditionally seen as a reliable safe haven for uncertain times. But fewer and fewer major defense firms are pure plays in the sector these days. In pursuit of what had been perceived as faster-growing markets, many in the sector increasingly earn revenues from commercial and other non-defense markets. Those firms with heavy commercial market exposure now face unprecedented economic headwinds.

Unlike many of its peers, BAE still earns nearly all of its revenues producing military equipment and providing military services. This contrasts with Airbus (OTCPK:EADSY) and Boeing (BA), both of which earn less than a third of their revenues from defense contracts. Raytheon Technologies (RTX), following its merger with United Technologies’ aerospace business, now also earns a substantial majority of revenues from its commercial aerospace divisions.

Companies that focus overwhelmingly on military markets have fared much better, benefiting from the long-term nature of military contracts and the relative stability of defense budgets. What’s more, amid rising geopolitical tensions, maintaining and modernizing defense capabilities remains a top priority for many governments.

BAE’s order intake for the first six months of 2020 reflects this – new orders was actually higher than the same period last year, at £9.34 billion, compared to £8.42 billion for the six months to June 30, 2019. Underlying sales rose 4%, although underlying EBITA decreased by 11% to £895 million on higher costs.

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BAE’s share price and valuations appear to be lagging behind others in the defense pure-play category, including Lockheed Martin (LMT) and Northrop Grumman (NOC).

2. Shifting Priorities

Although defense spending will likely prove resilient going forwards, defense priorities are changing. Even before the pandemic, we saw governments concentrate more resources towards electronic warfare, as well as cyber, intelligence, and security capabilities. This shift in priorities will likely only accelerate in the post-pandemic world, and the prospect of this happening seems to be in BAE’s favor.

Electronic Systems is the company’s second-biggest division, representing nearly a quarter of the group’s revenues, with it having significant exposures to growing areas in electronic warfare, surveillance and communications intelligence. BAE has even bulked up its offerings here with the acquisition of Collins Aerospace’s military GPS business from UTC for $1.9 billion and Raytheon’s airborne tactical radio business for $275 million during this year.

The company is also a leading supplier of cyber, intelligence, and security capabilities. The US-based Intelligence & Security business continues to perform well and has increased its bid pipeline, with sales up 5% on a like-for-like basis in H1.

3. Valuations

It’s not easy to make comparisons with those defense players with heavy commercial market exposure, given the crash in earnings that they are experiencing right now. But what seems to be clear is that BAE is trading at a substantial discount. With a forward price-to-earnings ratio of 11.2, the company is valued somewhere between a 20% and 30% discount to US defense pure-play peers Lockheed Martin and Northrop Grumman.

On a price-to-sales ratio, the stock looks even cheaper. It is valued at roughly half the level of its pure-play peers and at the lower end of the range of its civil aerospace-exposed peers. This can only be partly explained by lower margins at BAE, which is forecasted to improve following recent higher-margin acquisitions.

For income investors, the dividend is attractive. BAE has resumed dividend payments, after deferring 2019’s final payment earlier in the year due to uncertainty about the impact of the pandemic on cash flows. A payment of 13.8p per ordinary share in respect of the 2019 final dividend was made on September 14, instead of the typical June payment date. This represented a 4.5% increase on the same period last year.

With a 4.8% forward dividend yield, BAE is one of the highest-yielding stocks in the sector. And in an environment where reasonable yields from stable, defensive sectors are hard to come by, it’s not something that can be easily overlooked. Sure, the payout ratio seems relatively high in comparison to Lockheed and Northrop Grumman, but it is still far away enough from being in the danger zone.

Moreover, BAE’s recent financial performance demonstrates the resilience of its earnings power. The balance sheet is relatively robust too, with credit rating agencies S&P, Moody’s and Fitch all giving the company a rating BBB (or equivalent) and maintaining stable outlooks.

Meanwhile, shareholders of Airbus and Boeing could wait years before dividend payments are resumed.

Potential Headwinds

Although spending on defense has so far held up well, there’s no certainty that it would continue to do so in the longer run. In BAE’s interim management report, the company warned:

In the medium to longer term, future defence expenditure in a number of our markets could be impacted as governments seek to rebalance their budgets due to financial impacts in response to the COVID-19 pandemic and any sustained reduction in oil prices.

The reference to oil prices is a reminder of the group’s significant exposure to the Middle East, which is widely considered as a source of risk that many of its US peers are less exposed to. On top of the economic risks that the oil price shock has posed, BAE is reliant on the continued approval of export licenses by a number of governments, which may prove increasingly difficult amid ongoing human rights concerns. Nearly a fifth of revenues are earned from the Middle East, compared to 47% from the US, 20% from the UK and 6% from the rest of Europe.

Elsewhere, BAE’s sizable pension obligations is another thing to worry about. Despite having recently injected an additional one-off £1 billion to one of its larger UK pension schemes, the group’s net deficit at the end of June rose to almost £6 billion on an IAS 19 accounting basis, following a reduction in the discount rate to reflect falling bond yields. What’s particularly worrisome is that unlike many other UK companies with similarly large pension obligations, BAE has not closed its defined benefit scheme to existing members, which will expose the company to growing liabilities in the future.

Final Thoughts

BAE’s relative undervaluation does partly reflect some added risks that the company has over US defense peers Lockheed Martin and Northrop Grumman. But with a near-5% dividend yield, exposure to emerging defense priorities and near-term acquisition catalysts, there’s substantial upside risk too.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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