BAE Systems: Aerospace Play at Discount

BAE Systems: Aerospace Play at Discount

BAE Systems: Aerospace Play at Discount

Summary

Dividend    Revenue    Profitability    Financial Strength    Investment Case
  • UK – based BAE Systems (BAE) is one of the leaders in global defence market. Its activity is split into 5 divisions with Air and Electronic Systems being the biggest.
  • Dividend is attractive at 4.8% and sustainable.
  • The company’s sales were up and profits were down in the challenging year. The company expects continued growth in the US and other geographies to support its future growth.
  • The company’s debt is larger than its equity due to the acquisitions made over the year. However over the last 5 years period debt has been in downtrend.
  • BAE performance is impacted by the state of global economy, defence budgets of governments and political events. That makes the stock relatively risky. Current stock price is low by historical measure and could provide investors with attractive longer term returns.

BAE Systems (BA) is one of the largest global defence and security companies with leading positions in the US, the UK, the Kingdom of Saudi Arabia and Australia. It was formed by a merger of British Aerospace and Marcony Electronic Systems and is involved in major defense projects such as Eurofighter Typhoon, F-35 Lightning II and Astute Class nuclear – powered submarines.

BAE has the following reporting divisions:

  • Electronic Systems – develops electronic warfare, military communication, hybrid electric drive systems and other products and services in the US and the UK.
  • Cyber & Intelligence – comprises of the US based Intelligence and Security business and the UK based BAE Systems detica business.
  • Platforms & Services – military contracts – based activities including land and armaments business in the US and advanced technology center in the UK.
  • Air – manufactures and provides in-service support for combat aircrafts (Typhoon, F – 35, Hawk) and electronic equipment for military aircrafts.
  • Maritime – manufactures and provides in – service support for submarines, complex warships, naval gun systems, torpedoes, radars and more.

The US is the largest geographic market of BAE with 45% of total sales. Reporting segments are dominated by Air with 38% of total sales followed by Electronic Systems.

In April 2020 the company made GBP 1 B contribution to its pension fund in order to accelerate the deficit reduction. The deficit was at GBP 4.5 B in 2020.

 Dividend

Dividend Dividend Yield 5Y Growth PayOut Ratio Ex-Dividend Date
GBP 0.237 per share 4.78% 2.5% per year 58% 2021 Oct 21

Dividend is yielding almost 4.8%. This is attractive dividend yield, especially if compared with peers from Industrials industry. Its payout ratio below 60% is also good. Despite the pandemic related crisis, the company increased dividend by 2% in 2020.

BAE free cash flow (FCF), as defined by the company, was GBP 0.367 B. It was affected by the one-off GBP 1 B contribution to pension fund. Dividend coverage by FCF is only 0.5x for the year. However the management targets FCF in excess of GBP 1 B in 2021 and 3 years (2021 – 2023) FCF to be more than GBP 4 B. Hence we could expect higher FCF coverage ahead making dividend more sustainable and paving the way for dividend growth in the future.

  Revenue

Revenue 5Y Growth Revenue growth over 2020 Company Outlook 2021
GBP 19.28 B in 2020

 

 

 

 

2.8%  p. a.

 

 

 

 

 

Total sales                      +5.3 %

By divisions:

Electronic Systems        +2.7%

Cyber & Intelligence      +4.6%

Platforms & Services     +5%

Air                                  +6%

Maritime                        +4.5%

+3% to +5% growth vs 2020

By divisions:

Electronic Systems       +4% to +6%

Cyber & Intelligence     -3% to -5%

Platforms & Services    -3% to -5%

Air                                  +7% to +9%

Maritime                        +2% to +4%

Despite the pandemic revenue is up 5.3% over the year with Air division contributing the most to growth. The US business grew and the UK and Saudi Arabia were stable last year.

Highlights of the divisional performance:

  • In the Air division profitability was impacted by the pandemic. The division delivered a strong performance on its main programmes: Qatar build programmes, ramp up of F-35 production, in-service support on Typhoon, Tornado and Hawk for international customers.
  • In Electronic Systems division US defense electronics business delivered standout performance while Controls and Avionics franchises were negatively impacted by the pandemic.
  • In Maritime division Astute Class submarine HMS Audacious and two Offshoer vessels, HMS Tamar and HMS Spey were accepted during the pandemic. The work is in progress to bring the Queen Elizabeth Class Carriers to operational status.

The company expects continued growth in the US business and other geographies as defense budgets are growing in all the main markets. The priorities for 2021 include full rate production on F-35 and US Combat Vehicles multi – programme delivery.

The disruption caused by Covid – 19 maybe behind the company. It should be able to generate decent single – digit revenue growth from the development of next generation products in the coming years. Improving economic conditions and growing defence budgets in BAE’s main geographies are tailwinds for its activity.

 Profitability

Profit 5Y Growth Net Profit Margin ROE Company Outlook 2021
EPS GBP 0.407;

Net Profit GBP 1.37 B

 

 

 

7.7% p. a.

 

 

 

 

 

 

7% in 2020

8.4% in 2019

 

 

 

 

 

29% in 2020

 

 

 

 

 

+3% to +5% underlying EPS growth vs 2020

By divisions underlying EBIT margin:

Electronic Systems         15% to 16%

Cyber & Intelligence       7% to 8%

Platforms & Services      8% to 9%

Air                                      10% to 11%

Maritime                           8% to 9%

The company’s EPS is down 12% over the year from GBP 0.464 to GBP 0.407. This is partly explained by the one-off tax benefit the company had in 2019. 5 years average growth, 7.7% per year, is robust.

The company uses underlying EBIT as its key measure of operational profitability. The Group’s underlying EBIT in 2020 was GBP 2.04 B and underlying EBIT margin was 9.8%.

The priorities for 2021 include, amongst others, improved profitability in Platforms & Services and Applied Intelligence, supply chain savings, automation of core supply chain processes.  HQ costs are expected to be 10% lower vs 2020. These measures together with top line growth should allow EPS growth at least in the middle of the range expected by the company, i.e., 4% per year in the coming years.

  Financial Strength

Company Capital Structure

In GPB Bln

Year 2019 2020  
Equity 5.407 4.643  
Cash 2.587 2.667  
Debt 3.397 5.424  
Net Debt 0.743 2.718  
Debt/Equity 63% 117%  

Debt increase in 2020 was impacted by GBP 1.7 B acquisitions of the Airborne Tactical Radios and Military Global Positioning System businesses. That led to operating cash flow to debt ratio of only 36%. Debt/Equity ratio is also high at 117%. However net interest payments are well covered by operating profit with coverage above 8x.

 Investment Case

The estimate of future stock price and investment returns based on P/E ratio

Assumptions of dividend and EPS growth over the next 5 years
We assume future dividend growth slightly higher than in the past, at 3% per year. So the total dividend income over the next 5 years would amount to GBP 1.30.

We assume EPS growth of 4% p.a. Then EPS in 5 years will be GBP 0.50 per share.

Projected stock price
Average P/E over the last 5 years (16.93) multiplied by EPS in 5 years = 16.93 x GBP 0.5 = GBP 8.38
Future Returns Based on the Assumptions
Stock price upside potential                                     68%    from the current price GBP 4.98

Overall return on investment*                                  94%

Compound Annual Return on Investment              14% p.a.

*- Includes the expected dividend income over the next 5 years and dividends are not reinvested.

BAE has resilient business model. It is well diversified by geographies and has wide range of long – term programmes with many of them lasting for years or even decade. Acquisitions, made last year, have led to high level of debt. Also the company’s businesses are sensitive to political events such as changes in defence policy of governments or sanctions on Middle Eastern countries. However as the global environment is highly uncertain BAE’s defence and security products are to be in demand. The company’s long history and strong reputation makes it a strong player in global defence space. Investors with tolerance to the mentioned risks could potentially be well rewarded in the next 3 to 5 years through stock price growth and attractive dividend.

Disclosure:

I have no position in the stocks mentioned in this article and do not intend to initiate any positions within the next three days.

Notes

Data source – the company’s financial reports, presentations and its website. Source of pictures – the company website unless otherwise stated. Colored circles next to headings mean an author’s evaluation of the relevant performance criteria of the company: green means positive, yellow neutral and red negative evaluation. There are many ways to estimate the future stock price. We use only one of them, the one based on P/E ratio. All estimates made in the article are for the informational purposes only. No taxation, brokerage fees and other expenses related to investing are considered in the estimates. The estimates are the result of the rule of thumb assumptions and the real outcome might differ materially from those estimates. As the future unfolds, macro events, not mentioned in the article, could impact the company fundamentals. Use the information in the article only as a starting point for your own due diligence.

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