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:

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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:

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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.