Since the September 11th terrorist attacks in 2001, the US defence budget has doubled to roughly $694bn in 2010. This represents 45% of the global total and is more than 11 times larger than Britain's £37bn defence budget. It's no surprise then that investors are worried that the Pentagon is about to get clobbered in the forthcoming round of austerity measures. BAE Systems, the world's second-biggest defence organisation, is a case in point. Its shares have lagged the FTSE 100 by 20% since October. But this seems odd to me.
Ashton Carter, the Pentagon's procurement chief, points out that "the country is at war, and I think people will continue to support a large level of defence spending. And you know it is our intention to keep that where it is and actually grow it slightly, in real terms." And while BAE is exposed to any US and British spending cuts, remember that it is involved in some of the most cutting-edge areas in military technology where budgets are actually being hiked. These include cyber-warfare, for which BAE supplies aerial drones, spy planes and covert surveillance.
In September, BAE also strengthened its position in counter-terrorism with the $296m acquisition of the consultancy division of American firm L-1 Identity Solutions. Then, in November, it was appointed as prime contractor to the FBI, on an eight-year, $30bn deal to overhaul its antiquated IT platforms.
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BAE Systems (LSE: BA), rated a BUY by Standard & Poor's
There are other buoyant regions beyond the traditional Nato countries. Britain has signed a bilateral agreement with Brazil that paves the way for BAE to supply the Brazilian armed forces. India hemmed in by powerful China on one side and belligerent Pakistan on the other is also a booming market that saw 35% growth in 2009.
Admittedly, some markets are completely out of bounds most notably China. China is the world's second-biggest spender, yet it makes its kit locally and has historically relied on Russia for know-how. Yet elsewhere, South Korea, the Middle East and Australia are all growing markets. Indeed, CEO Ian King recently commented that the group was "trading in line with expectations" and was less affected by the gridlock afflicting decisions made in the US than many of its rivals.
Britain's 7.5% cuts (in real terms) should only knock about 1p a year off earnings per share (EPS) or less than 2.5% of 2010 targets. The City is forecasting 2010 sales and underlying EPS of £22.6bn and 42.5p respectively. That puts the shares on a derisory p/e ratio of 7.8, with a 5% dividend yield. I would value the stock on a nine-times earnings before interest, tax and amortisation (EBITA) multiple. After adjusting for the £4.9bn pension deficit and net debt of £1.2bn, that generates an intrinsic value of 390p.
So what are the big risks? Governments are tightening their belts on both sides of the Atlantic and there are the usual problems of operating in the military sector, foreign-exchange fluctuations, and contract delays. There are also ongoing negotiations with Trinidad and Tobago officials over the cancellation of its offshore patrol boats this could hit profits by £150m.
But with a £43.6bn order book, high-tech expertise, further cost-cutting opportunities and solid prospects in emerging markets, the shares are a buy. Preliminary results are due out on 7 February and Standard & Poor's has a 450p price target.
Recommended BUY at 330p
Disclosure: I own shares in BAE
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