BAE income portfolio candidate

A global defence, aerospace and security company. BAE Systems delivers a range of products and services for air, land and naval forces, as well as advanced electronics, security, information technology solutions and support services.  I have a holding in my income portfolio (epic code: BA.)

 

Market/Index	Full/FTSE 100	Industry	Aerospace & Defence
Sales	£16.6bn	Earnings	$1.1bn
Market Cap	£12.5bn	Share Price	387p
Norm. EPS	30.0p	Historic P/E	12.9
Est. 2013 growth	39.9%	Prospective P/E	9.23
Est. 2014 growth	-2.5%	Prospective P/E	9.47
Historic Yield	5.04%	Rolling 1yr Yield	5.29%
Dividend cover	1.67	PBV	3.37
ROE 5 yr Ave.	19.4%	Operating Margin	9.9%
5 yr BV + Div return	3.8%	5 yr FCF return on BV	12.3%

BAE Systems one of the income portfolio candidates is the world's third largest defence company.  The following chart compares the relative sizes of the competition:

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Following confirmation of Sir Roger Carr as their new Chairman, it appears that little will change with respect to their long-term strategy, defined as growing the cyber intelligence and security division along with the electronic systems division, expanding sales to non UK and non US markets and increasing the value from their much larger platform and services divisions.  The later are unlikely to see much growth over the next couple of years.  The company is committed to buying back £1bn of stock over the next 3 years, although this total is reliant on success with current price negotiations with Saudi Arabia on the SALAM Typhoon programme, that success would also add 3p to this year's EPS forecast.

The 2012 results were significant in that every division showed a book to bill ratio above 1 for the first time in many years.  The following bar chart shows orders, sales and each division's book to bill ratio:

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The chart below details the operating margin by division, the highly competitive nature of the US platform & service market is evident from the lower margins achieved, although it worth noting sub-system suppliers to the prime contractors achieve higher margins.  The lower margins from cyber & intelligence seemed to me to be intuitively low, but looking at Booz Allen Hamilton a $6bn US company in this market, who achieve operating margins of 7-8%, BAE's margins at just below 9% are probably at the right level.  Which will mean, as this side of the business expands, dilution of operating margins, although improved capital turnover due to lower requirements for working capital.

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 It is well known that BAE is affected by the sequestration in the US, a rather forced blunt instrument to reduce spending by $85bn this year and $1.2tn over the next 10 years.  Unless the US comes to grips with this and produces a more targeted reduction, rather than the sequestration's "across the board" approach, BAE along with all other primes will be adversely affected.  The importance of the US to BAE's well-being is shown in the chart below, which is not surprising since the US accounts for approximately 40% of world defence expenditure and more than the next 10 high spenders combined.  So keep an eye on events in the USA, any resolution should positively impact BAE and their long-term plans, no short-term resolution may have an adverse affect on this year's numbers:

Click on chart to enlarge

As an income investment, BAE offers a high prospective yield of almost 5.3%, well covered in terms of expected earnings of almost 2x.  Following 2 years of poor free cash flow (FCF) generation, 2012's FCF offered good cover at 2.8x and if the SALAM contract negotiation is concluded, this year's FCF cover will likely increase.  BAE have a record of increasing dividends for the last 9 years with a CAGR of 8.8% pa, having frozen the pay-out in 2003.  So a high well covered yield with inflation protection, from a company with a record of returning cash to shareholders. 

I am less impressed by their £1bn share repurchase programme, at a current P/BV of over 3, this will not be net incremental to owner's earnings (book value per share plus dividend per share).  As can be seen from the table at the top, although FCF is reasonable over the last 5 years, the book value per share has depleted the owners' earnings, mainly due to actuarial losses on defined benefit pension schemes.

I rate BAE as having a wide moat due to 1) their intellectual property embedded within their systems and their undoubted know how; 2) switching costs of customers, once they have designed in a BAE platform or system it would be prohibitively expensive to design them out and dual sourcing is rare if non-existent and 3) scale, as the 3rd largest defence contractor in the world they are able to benefit from their size, which in the defence industry is important.  This is reflected in an average return on equity over the last 5 years of close to 20% and operating margins approaching 10%, this compare well with their major competitors Lockheed Martin, Boeing and GD and show BAE as having a durable competitive advantage.

A reduction of US involvement in wars, will produce a negative short-term impact on primes such as BAE, through a substantial reduction in urgent operational requirements or needs.  There will though eventually be major upgrade programmes on existing platforms required and an increase in development programmes that would have been slowed or postponed due to war activity.  DOD's 2012 strategic guidance states:

"...we will resist the temptation to sacrifice readiness in order to retain force structure, and will in fact rebuild readiness in areas that, by necessity, were de-emphasized over the past decade..."

They also stated:

"...Protecting readiness also requires resetting damaged and worn equipment after years of war..."

We live in a world of uncertainty and just the verification of safety requires defence expenditure.

Detailed below is a short summary of the strengths, weaknesses, opportunities and threats that I attribute to BAE:

Click on chart to enlarge

 
I view BAE as a good income portfolio candidate requiring further research, available at a reasonable price for a company with a durable competitive advantage.
 

Bhp Billiton JV

A diversified natural resources company and among the world’s largest producers of major commodities, including aluminium, coal, copper, iron ore, manganese, nickel, silver and uranium, and has substantial interests in oil and gas.  I have a holding in my income portfolio (epic code: BLT).

BLT announced today that Itochu Corp. and Mitsui & Co. Ltd. will invest approximately US$0.8bn and US$0.7bn respectively in shares and loans of BHP Iron Ore (Jimblebar) Pty Ltd, representing an 8% and 7% interest in the Jimblebar mining hub and resource.

The mine will have an initial production capacity of 35m tonnes and Itochu & Mitsui will secure 5m tonnes annually (approximately 4% of Japanese requirement) from the deal.

Mitsui and Itochu already collectively have a 15% stake in BLT's Western Australia Iron Ore mine, rail and port infrastructure.

Including this deal, BLT have divested just over $8bn since April 2012, as part of a divestment programme that is expected to realise $25bn; thereby substantially reducing their $30bn debt and giving them increased flexibility to improve cash returns to shareholders.

 

Melrose Industries disposal

Melrose Industries, an engineering company that seeks to acquire businesses it understands, improve them by a mixture of investment and changed management focus, realise the value created and then return it to shareholders. I have a holding in my income portfolio (epic code: MRO)

Announced today that it has signed an agreement for the sale of their subsidiary Marelli Motori for €212m, which equates to 12.6x EBIT and 9.5x EBITDA.  This is a reasonable price for a generators and electric motors company and higher than the much larger Dynacast disposal back in June 2011 (9.1x EBIT and 7.7x EBITDA).  It is worth noting though that the Melrose group is on a valuation that is approximately double this, possibly implying that we can expect much higher valuations from some of the other parts.

Halma Finals

Designs, manufactures & markets equipment for process safety, infrastructure safety, medical and environmental & analysis.  Typical products include - fire detectors, gas detectors, water treatment systems, ophthalmic instruments and machine safety systems.  I have a holding in my income portfolio (epic code: HLMA)

Announced full year results today and, as indicated in their earlier updates, were in line with market expectations.  This has been a common theme over the years from an extremely well run company.

Full year revenue increased by 7% to £619.2m, with organic growth of 2% and 3% using constant currency.  Adjusted PBT increased by 8% to £130.7m, organic growth was 4% which was 5% using constant currency.  Excluding businesses sold during the current and prior years, revenue grew by 9% and PBT was up by 10%.  Order intake in the second half remained slightly ahead of revenue ensuring that they made a positive start to the 2013/14 financial year.  Adjusted EPS increased by 7.2% to 26.22p and statutory EPS increased by 9.6% with the higher acquisition related expense being more than offset by the £8.1m profit on disposal of Tritech. Total dividend for the year is 10.43p up 7.1% and represents the 34th year that dividend increases have been 5% or greater.

The company operates in markets that have solid long-term growth drivers - increasing health and safety regulations, increasing demand for healthcare and increasing demand for life critical resources such as energy and water.

Operating in these markets Halma delivers high double digit operating margins and ROE; owners' earnings (book value growth and dividends) have delivered 21% pa over the past 5 years, backed up by a free cash flow return of 20%. 

When I first purchased Halma back in 2007 they were offering a yield of 3%, today unfortunately they yield just 2.1% (although 4.5% on my original price).  This is the main reason that in 2011 I sold a large part of my holding, to reinvest in higher yielding stock that were also growing their dividends - Reckitt Benckiser and Unilever.   

Very rarely are these shares offered at a cheap price, but as  Warren Buffett said“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”  

 

Craneware growth portfolio candidate

Develops, licenses and supports computer software for the United States healthcare industry, assisting hospitals and other healthcare providers with automated revenue integrity.  This will include automated billing, strategic pricing, supply management and audit & revenue recovery.  I have no holding in this company (epic code: CRW)

Market/Index	AIM/AIM 100	Industry	Healthcare Equipment & Supplies
Sales	$41.1m	Earnings	$8.89m
Market Cap	£102.6m	Share Price	383.5p
Norm. EPS	$0.33	Historic P/E	18.1
Est. 2013 growth	3%	Prospective P/E	17.6
Est. 2014 growth	15.0%	Prospective P/E	15.5
Rolling PEG	0.85	SGR	12.8%
PBV	4.30	Historic Yield	2.76%
ROE	25.5%	Operating Margin	27.0%
5 yr BV + Div return	64.5%	5 yr FCF return on BV	53.9%

CRW was one of the recent additions to the growth portfolio candidate list here.  It was founded in 1999 and came to the AIM market in 2007.  Since its IPO sales have grown by 22% pa and EPS by 44% pa.  Their operating margins over that period averaged 21% and today sit at an impressive 27%, with a ROE of just over 25%.

CRW suffered a fall in its SP following a January 2012 announcement that stated "...we have seen sales cycles extend for all the Group's product families. The Board believes this is due to an unexpectedly high percentage of healthcare providers choosing to focus on achieving the 31 December 2011 deadline for the first Electronic Health Records Incentive Payments..."  The SP has not really recovered from this fall.  Despite 32% & 20% EPS growth for their June year-end 2012 & recent half-year results.  They also stated at their half-year "...We believe the disruption to our market caused by the focus on Electronic Health Records incentive payments has largely dissipated, freeing up hospital resource to focus on other areas of technology investment..."

CRW is a company with good visibility of revenue, at the half-year CEO Neilson stated that he had visibility of $39.7m sales for the full year compared to $33.4m last year, an almost 19% increase.  Analysts have pencilled in a 10% increase in revenues for the full year, with just a 3% growth in EPS.  Although analysts are more bullish for 2014 & 2015 estimating 15% & 23% growth respectively.  The forecasts for this year may just be a case of analysts being cautious following the problems during 2012.

CRW compete with some extremely large corporation in the USA, in a market that is extremely fragmented.  MedAsset and Emdeon are two such competitors with sales of $640m and $1.1bn respectively.  It is interesting to note that Emdeon following their acquisition of EquiClaim in 2011, were themselves acquired by private equity company Blackstone in the same year, just 2 years after Emdeon's IPO.  It would seem to me that given the structure of such a fragmented market, the large participants and high returns available, that CRW is likely to eventually be acquired by one of those US corporations.

I would judge CRW to have a narrow economic moat, due to 1) the cost of a client switching out of their software once installed and 2) the intellectual property embedded in their software, that is most evident by their returns they are able to achieve.  A company with a good durable competitive advantage and a strong balance sheet - turning over net assets almost 5 times and $29m of net cash.

In summary, a reasonably priced candidate  for a growth portfolio (if you strip out the cash, the historic P/E drops from 18 to 13), earning good returns, with the potential kicker of an exit by way of a takeover.

IG Group trading statement

Engaged in derivative trading services, providing financial contracts for difference, spread betting and exchange-traded derivatives to retail investors internationally.  I have a holding in my income portfolio (epic code: IGG).

IGG issued a trading statement declaring that it expects to report trading revenue of £104.3m for the final quarter of the year, 8% ahead of the same quarter last year.  This will give £361.9m for the full year, 1% behind the prior full year, but more than 2% above market expectations.

 

Stronger H2 revenue and one-off items of £4m will positively impact their Profit Before Tax and they expect it to be ahead of the prior year.  The main element of this £4m relates to their successful defence in the legal case, served in November 2010, arising from the insolvency of Echelon Wealth Management, the plaintiffs have paid a substantial contribution to the legal costs incurred by IG

 

Following the reduction in operating costs in 2013, IG expects these to rise in 2014.  This Increase in costs in FY14 is planned to drive future growth, although it is not anticipated that this investment will deliver any significant revenue benefit in the current year. 

 

There was a negative comment relating to their Japanese operation (less than 6% of sales), new rules from the regulator limit the use to one type of binary options, which are not currently offered by IG, but do constitute the principle forms of binary offered by a large number of competitors.  One does wonder how long it will be before IGG take the decision to close their Japanese operation.

With the increase in their cost base and the continued problems in Japan, it will put pressure on their ability to increase profits in the current year.  There is a risk that future dividend increases in the short-term will no longer comfortably exceed inflation, having grown by over 20% pa for the past 5 years.  IGG have a policy of distributing 60% of earnings from a good cash generative business, but they are exposed to requiring high volatility within markets to generate growth in their business.  IGG is not a company with an economic moat, it has no perceived durable competitive advantage other than its competent operating systems. 

I have held IGG for 4 years and they represent 3% of my income portfolio, having halved my holding about 2 years ago.  It may be time to look at an exit, having achieved a return of just over 25% pa (dividends not reinvested), it would be disappointing to see returns diluted.

Globo trading statement

GLOBO

A technology innovator delivering mobile, telecom and e-business software products and services. I have a holding in my growth portfolio (epic code: GBO).

 

 

Globo released a statement  ahead of its AGM, reporting a 130% rise in subscribers to GO!Enterprise, its cloud-based mobile services product, in the past year.  Following launch at the end of 2011 the initial revenues of €2.0 million, rose to €12.0 million in 2012. 

 

They also stated that so far in 2013 they have continued to achieve strong revenue and profit growth across both enterprise and consumer segments. Overall, they stated that they are in an excellent position to address the BYOD trend and are confident that 2013 will deliver further profitable growth for shareholders.

 

Key to growth for Globo is in developing their position in the US market.  Although they remain confident, many of their competitors are much larger established corporations.  In a separate statement to the press, CEO Costis Papadimitrakopoulos stated that they are looking at possibly two acquisitions either to boost its product portfolio or to enter new markets.  He estimated that they may pay approximately $10m for a typical acquisition.  In addition to the organic growth challenge in the US, this will increase the execution risk, not least because of the amount of management time required to integrate two acquisitions.