BAE Systems: Time To Play Defence

Thesis Summary

BAE Systems (OTCPK:BAESY) is a UK-based defence contractor with operations and revenues spread around the world.

The company has been increasing revenues steadily and has performed even better since the beginning of the Ukraine war.

I believe the conflict in the Middle East could also act as a catalyst to increase worldwide defence spending, which will increase BAE’s revenues.

This company is part of my End Of The World Portfolio due to its robust sources of revenues, secular growth, moat and strong balance sheet.

Though BAE is an international company, investors can easily get access to the stock through its ADR.

BAE Overview

BAE Systems is a UK-based defence contractor operating through five main segments: Air, Maritime, Cybersecurity and Intelligence, Platforms and Services and Electronic systems

The company boasts revenues of over $5 billion, and we can see how they are distributed by segment below:

Air makes up most of the revenues, while electronic Systems and Maritime come next.

Below, we can also see the sales breakdown by product.

Defence electronics make up over half of the Electronics systems revenue. These are mostly equipment used in aircraft. For example, BAE products have. a strong presence in the US fixed and rotary wing platforms.

The company is also involved in the design of various submarines and aircraft. The F-35 Lightning II is one of the newer models, and the company expects to be producing over 3000 of these in the next decade.

BAE designed the Astute Class nuclear-powered attack submarines for the Royal Navy, of which there are now five, and two more will come online in the mid-2020s.

Lastly, we can see that BAE plays a big role in providing intelligence and cybersecurity to the US and UK governments, a programme that is now expanding into Australia and Japan, too.

BAE Systems has clients from around the world, and it has done very well, especially in the last year, as it achieved revenue growth of 12%.

Indeed, revenues were boosted following the breakout of the Ukraine war, and this was anticipated by the stock price, which got an almost instant boost.

As markets opened on Monday, following the escalation of the Israel-Palestine conflict, BAE Systems stock rose by around 5%.

Why I like BAE

I think BAE Systems will benefit from the escalation of the conflict in the Middle East. However, there are a lot more reasons why I like BAE Systems.

In fact, BAE has been a part of my End Of The World portfolio for some time, as it excels in many of the characteristics that make a stock resilient and a good long-term hold.

Secular Growth

BAE won’t grow revenues at 50% YoY, but I believe it will be able to deliver consistent and steady growth. This is the path government spending has taken in the last 20 years, and I see no reason this will change. Furthermore, defence spending will likely accelerate even faster.

Statist projects that US defence spending will reach $1 trillion by 2030

Revenue Resilience

Another great thing about BAE is that its revenues are resilient due to its global diversification:

BAE receives 44% of its revenues from the US, 20% from the UK, 17% from the Middle East and 13% from Europe. This makes the company quite immune to sudden changes in revenue.

On top of that, BAE has an order book of over $50 billion

On August 2nd, BAE increased its order backlog outlook to $84.5 billion.

With a record order backlog and good operational performance, we’re well positioned to continue delivering sustained growth in the coming years, giving us confidence to continue investing in new technologies, facilities, highly-skilled jobs and in our local communities.

Source: Charles Woodburn, chief executive

This was at a time when BAE Systems also scored a contract with the Czech Republic.

And since then, the order backlog has probably grown even further. It seems that every other day BAE is securing another contract.

On October 2nd, the company secured a $4.8 billion deal with the UK for nuclear submarines.

On September 28th, it expanded an Army contract for $288.25 million.

September 26th, a $319 million contract with the army to provide MPE-M Cards.

And on September 18th, $500 million from Sweden to provide an additional 48 ARCHER artillery systems.

Moat

Needless to say, companies in this line of business are generally quite insulated from competition. BAE has billions in infrastructure and has built relationships with governments around the world. This is not something that can be easily replicated.

Balance Sheet

While not the strongest of its attributes, BAE Systems has a relatively strong balance sheet.

Assets more than cover liabilities. The Debt/Equity ratio is 0.62, and the interest coverage is around 9.3 Overall, I wouldn’t expect BAE to have any financing problems moving forward.

Valuation

And, of course, even after the recent run-up, BAE has a compelling valuation:

As is often the case with foreign companies, BAE trades at generally lower multiples than American companies. The PE is still below the sector median. The PEG is only 0,35, and the stock trades at under 8x cash flow.

To top things off, BAE pays out a 2.59% dividend yield.

Based on these multiples, BAE Systems stock seems undervalued. If the PEG were to catch up with the sector median, we could expect the stock price to almost double.

Risks

BAR has done very well in the last few months, but there are still some risks that investors should be aware of.

Given the nature of BAE’s industry, there is always a risk that engineering mistakes could lead to recalls or slowdowns in deliveries. BAE’s products are highly technical, and even a small mistake could have a large impact on revenues.

Also, we have to consider the idea that in the face of higher rates, some countries might be looking at cutting spending in the coming years.

Takeaway

BAE Systems is, in my opinion, a great all-around stock, which provides investors with a good “hedge” against war. Unfortunately, extended periods of peace are an anomaly in human history, and we are beginning to see signs of what could come.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.