BAE Systems (BAESY): a safe 3% dividend, but not the main beneficiary of the US defense budget

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Introduction

BAE Systems plc (OTCPK:BAESY) is a defense company providing advanced defence, aerospace and security solutions worldwide. Due to the recent conflict in Ukraine, defense companies have taken advantage of this. Recent company performance highlights some improvements for the company however, competitors seem to be in a better position to grow in the future. Below, we summarize the 2021 financial results and highlight that BAESY is holding steady at current levels. Nonetheless, defense companies have generated positive returns year-to-date.

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Complete results for the 2021 financial year

BAESY published its annual report in March 2022. Below, we will take a closer look at the top and bottom results as well as the company’s leverage.

Turnover, operating result and net result

Own analysis

As we can see from the graph above, it is clear that the company’s revenue stream is relatively stable, which we highlighted in our previous article. Over the five-year period, turnover increased by 1.9% on average, operating profit by 6.5% and net profit by 15.9%. Year-on-year, revenue increased by approximately 1.3%, operating income by 23.8% and net income by 47.2%.

Margins

Own analysis

As expected, the company’s profitability illustrates the same points we mentioned above. Operating and net profit margins are at historically high levels and for the full year 2021 they were 12.2% and 9.8% respectively, the highest in the past five years.

Coverage of debt and interest

Own analysis

We would like management to focus on improving the company’s financial condition. Debt has decreased over the past year and the interest coverage ratio has improved. At the end of financial year 2021, debt stood at £5 billion and the interest coverage ratio at 8.6x. However, as the graph above illustrates, the company’s debt is higher than 5 years ago. Given historically low interest rates globally, we expect companies to benefit, however, monetary tightening around the world should prompt management to deleverage the company’s balance sheet. Interest coverage shows that the company is not in financial difficulty, but we expected more leveraged balance sheets to suffer in the short to medium term. Finally, the company has a defined benefit liability of almost £4.2 billion. Pension regulators are putting more and more pressure on companies to make sure their pensions are well funded and we expect that the company will have to pay higher and higher contributions to make up this shortfall. . Both carry higher risk for shareholders and should be closely monitored.

Dividend and share buybacks

BAESY has paid a growing dividend and we expect this to continue to be the case. For the full year of 2021, the company paid 25.1 pence per share, a 6% year-on-year increase. The company has paid an increasing dividend over the past 18 years and for 2021 has bought back £500m worth of shares. We believe the dividend is safe at current levels as the payout ratio is around 41% and CFO dividend coverage is 3.1x. These two parameters are at historically good levels and the best of the last 5 years. Given the stability of the company’s income streams, we believe the dividend is safe.

The company’s current dividend yield is 3.3%. A constant dividend growth model with a growth rate of 3% and a discount rate of 8% suggests that the fair value of the company would be £5.3 per share. The current share price is £7.7, suggesting the company is 30% overvalued. Given high levels of inflation and the current stock price, we believe the company does not have much upside potential.

Relative valuation

Given the recent conflict in Ukraine, defense companies have rallied and should continue to do well as governments around the world seek to restock their arsenals.

OTCPK:BAESY

NOC

RTX

LMT

PER

13.0

12.9

33.8

19.8

P/S

1.2

2.1

2.1

1.9

P/Cash Flow

9.3

23.1

20.4

13.4

ROA (%)

6.5

13.8

2.6

12.6

ROE (%)

29.1

48.4

5.9

76.1

Source: Alpha Research

When comparing price multiples and return on assets (ROA) and return on equity (ROE), the company appears to be undervalued relative to Raytheon Technologies Corporation (RTX). On a price multiple, it trades at a discount to Northrop Grumman Corporation (NOC) and Lockheed Martin Corporation (LMT). However, we expect NOC and LMT to perform better and deliver better ROA and ROE than BAESY, so higher price multiples are warranted.

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In addition, BAESY multiples have increased since the start of the year by around 30%. Given the conflict, however this is expected, shareholders should also bear in mind that they are also more exposed to downside risk given the rally since the start of the year.

Risks

We see two major risks for the business. First, defense companies benefited from multiple expansions during the conflict in Ukraine. As mentioned above, BAESY’s price/earnings ratio has increased by 30% since the start of the year. A de-escalation of the situation will lead to price cuts for these companies. Even though it looks like the world is going through a security crisis with multiple risks on a global scale, immediate de-escalation is likely to lead to downward pressure for these companies as shareholders will seek to exit these positions. Furthermore, we do not consider BAESY to be the best place to take advantage of the expected increased demand. The conflict in Ukraine has led Western governments to provide resources to the Ukrainian government and will seek to replenish their stockpiles. BAESY’s largest sales market is the United States (45% of sales) and they have played a leading role in pushing other governments to repel Russian aggression. However, at the same time, the notion of national security and not depending on foreign companies to provide essential services is on the rise. Therefore, we expect the size of the defense budget to grow, but at the same time we expect local defense companies to benefit the most, as governments will be even more careful in increasing of their dependence on any other country. Therefore, given the size of the US budget, the assistance provided to Ukraine and the notion of increased localization of critical services/goods, we do not consider BAESY to be a UK based company. as the primary beneficiary. Instead, NOC and LMT could benefit more.

Final remarks

BAESY operates in a stable industry and its financial performance has improved in 2021. The performance of the last 5 years indicates that the company is moving in the right direction. Risks related to debt and pension commitments must be taken into account to guarantee the security of the dividend. Additionally, we believe that other defense companies are better positioned to benefit more in the short to medium term due to the location of critical goods and services. BAESY is holding at current levels.

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