Questor share tip: BAE Systems lifted by global tension

BAE Systems
456p+10.9p
Questor says HOLD

The case for investors holding BAE Systems [LON:BA] as a good long-term defensive investment with income potential was underpinned yesterday by a supportive analyst note that sent the shares up almost 3pc.

Bank of America Merrill Lynch issued a double upgrade on BAE, lifting its recommendation from underperform to buy.

The note, which stretched to 26 pages, points out that the increased possibility of war in Eastern Europe is good for shares in companies that make tanks, artillery, missiles and fighter jets.

At 456p, BAE shares are trading near the top of their long-term price range. During the past two decades the stock has twice climbed to just above 500p – in 1999 and once again in 2007 – and fell as low as 100p during 2003.

Looking back over the past 20 years, the most obvious level of support for the shares has been around the 300p level, or down about 33pc from today.

During these moments of market weakness the company has remained a solid dividend payer.

The shares currently offer a 4.6pc prospective yield, while the 20.4p annual dividend is covered 1.8 times by forecast earnings per share of 37.2p. The dividend growth is meagre, with the market expecting a 2pc rise this year and next.

That said, 4.6pc income is much better than anything on offer in certain other sectors, such as banking.

However, BAE’s balance sheet doesn’t look that secure as debt levels are rising sharply – and paying dividends out of debt is unsustainable in the long term.

Analysts forecast net debt levels to rise to almost £1.7bn at the end of the year, more than double the £700m seen in 2013. As the turnaround in defence spending takes a while, net debt will increase again to about £2bn by the end of 2015. Putting that in perspective, shareholders’ equity is £3.4bn.

The dividend payments can be protected by sacrificing the £1bn share buy-back programme, which BAE announced in February 2013. The company spent £215m on its own shares last year, and is on target to buy back £380m this year. The remainder, around £400m, available for 2015 will depend on big new orders being signed in the next four months.

The military jet maker has now concluded its two-year price negotiations on the “Salaam” contract with Saudi Arabia for 72 Eurofighters. This clears the way for new contracts with Bahrain, Kuwait, Qatar and the UAE.

The outlook for the US – BAE’s largest market, making up 37pc of the group’s total business – has also stabilised. America’s defence budget is expected to remain flat for the next two years, having dropped 30pc from its 2010 peak.

Defence spending has been increasing in Europe, and this looks set to accelerate in the light of the Ukraine crisis. Europe only makes up a small portion of BAE’s overall business, but an increase in spending by countries such as Sweden and Poland is supportive of the wider sector.

BAE’s shares are currently trading on 12 times forecast earnings, falling to 11.5 times next year. The company looks like a good long-term bet, as its problems look like they are priced in.

The shares trade at a discount of about 10pc to US peers and about 14pc to UK rivals.

But, while BAE Systems remains a solid hold, the shares are no better than that, with the current trading price near the top of the long-term range.