Equities endured more volatility last week amid fresh fears of a US recession, sky-high oil prices and concerns over the health of banks. We can’t be sure of many things going ahead, but what’s certain is that there will be a new president in the White House come the end of the year. So what does this mean for the defence industry?
BAE Systems (BA.), tipped as a BUY by The Daily Telegraph
Given the importance of the war on terror and the need for homeland security, I think it would be political suicide for either the Republicans or the Democrats to campaign for budget cuts and thus risk being accused of putting US lives in danger. So for at least the next two years, US defence plans should continue in robust health. And the numbers are enormous. At last count, it is estimated that in 2008 the US will spend around $481bn on its basic military needs (up 11.3% on 2007) and a further $142bn on anti-terrorism measures.
BAE is the world’s third-largest defence group and also specialises in the marine, electronics, avionics and armoured vehicle sectors. Last Friday it beat many City forecasts with a sparkling set of figures. Turnover for 2007 rose 14% to £15.7bn, driving adjusted earning per share (EPS) up by 30% to 31p and the dividend up 13% to 12.8p.
Even more reassuring was the massive £38.7bn order book (up 22%), which offers great visibility going forward. Notable contract wins included 72 Typhoon fighter aircraft from Saudi Arabia and mine-resistant vehicles for use in Iraq. Cash generation was also strong, leaving net funds of £700m at the year-end and providing the company with plenty of ammunition for more acquisitions, such as last July’s £2.2bn purchase of Armor Holdings.
UBS expects 12% annual earnings growth over the next three years (with adjusted EPS rising to 36.0p, 40.3p and 43.7p) on the back of a robust US market (representing 38% of BAE’s revenues), together with the group’s exposure to the attractive armoured carrier and military aviation segments. Both of these are relatively immune to the economic cycle.
So what do we need to watch out for? Firstly, there is an investigation by the US Department of Justice into the alleged bribery of officials by BAE over the £43bn Al-Yamamah arms deal with Saudi Arabia in 1985. Next, America’s military budgets could be trimmed from 2010 onwards, especially if Congress decided to wind down US involvement in Iraq and Afghanistan. However, the new Saudi Typhoon work will start in 2009, providing revenue protection even if the US eases off the gas.
Thirdly, UK spending could also come under attack with programs being delayed, or even cancelled. One such project likely to be pushed back is the Ministry of Defence’s order for two aircraft carriers at a cost of £3.6bn. Lastly, there is exposure to the dollar, while BAE’s backlog contains some legacy fixed-price development contracts that must be managed carefully.
But with a rock-solid balance sheet, good earnings visibility underpinned by a huge backlog and opportunities in regions such as India to boot, BAE looks a solid choice for the cautious investor. The stock trades on undemanding p/e multiples of 13.3 and 12.0 respectively for this year and next and pays a 3% dividend yield.
Recommendation: BUY at 499p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments