BAE Systems: a stock to tuck away for uncertain times

The Ukraine war and rising energy prices are driving the narrative for investors this year. So it’s no surprise that the best-performing stock in the FTSE 100 this year is Shell (LSE: SHEL), closely followed by BAE Systems (LSE: BA).

BAE Systems: a unique company in a unique market

The defence industry is unique. Most markets are dominated by competition and cycles that can lead to overexpansion, overproduction and price swings, but in the defence sector companies usually agree to large, long-term fixed contracts with their customers, primarily government bodies.

Granted, there is some competition; companies have to make competitive bids for contracts and there’s always going to be the chance they won’t win. However, at the top end of the market the biggest companies usually have access to unique tech and skills not available to smaller players. Therefore, they have an unrivalled competitive advantage.

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For example, BAE Systems is the lead member of the Aircraft Carrier Alliance, a “unique partnering relationship” with the private sector that’s working with the Ministry of Defence (MoD) to deliver the two QE class aircraft carriers.

As the largest defence contractor in the country, BAE was always going to have a major role to play in constructing and maintaining these ships. The contract will deliver billions in revenues for the group over a multi-decade period.

BAE earns recurring revenue streams on fixed contracts with large and stable customers suggesting it is in a great position to navigate the prevailing economic climate.

And with governments around the world increasing defence spending in the face of rising aggression from Russia and China, it looks as if BAE will have the chance to grab even more business in the years ahead.

BAE has the potential to grow in a tough market

Earlier this year the FTSE 100 company reported a 5% increase in sales for 2021 and told shareholders that it expects the “complex threats” facing the world to boost its business. Management also claimed that the need for governments to drive a “domestic economic prosperity agenda after the coronavirus pandemic” would also lead to sales growth.

In the US, the world’s largest defence market, a new spending bill was signed into law at the beginning of March which increased defence spending to $743bn this year and $773bn in 2023. As the US is one of its largest markets, BAE will benefit from this spending.

Since publishing its full-year figures, the group has also won a string of contracts, most notably a £590m 11-year deal to support the UK’s Hawk training aircraft fleet and contracts worth £2bn in alongside Rolls-Royce (LSE: RR) to support the UK’s £31bn nuclear deterrent renewal programme. Other agreements include a seven-year support, sustainment and readiness contract for Norwegian armoured vehicles and ship repair and maintenance agreements for the USS Essex and USS Mustin.

BAE is a major player in the global defence market. This competitive advantage is here to stay. With decades of experience behind it, the organisation has access to technology and resources other firms can only dream of owning. What’s more, in this highly sensitive and secure industry, BAE has proven that it can be a trusted supplier.

The company ended 2021 with an order backlog of £44bn, which is around two years’ worth of revenue at current rates. It generated net operating cash flow of £2.5bn on an IFRS basis and its share of net post-employment benefits deficit more than halved to £2.1bn. The pension deficit, which has long been a drag on the company, finally seems to be coming down and this will free up more capital for the group.

Indeed, capital returns are already on the cards. Management raised the firm’s dividend for 2021 by 6%. It also announced a £500m share buyback last year and with the group projecting £4bn-plus of cumulative free cash flow between 2022 and 2024 it looks as if management will have the capital available for more shareholder distributions. The stock yields 3.4% today.

Building a foothold in a growing sector

BAE is best-known for its defence business and that’s what I’ve concentrated on in this article so far. However, the group also has a growing cybersecurity and intelligence arm. I think this deserves closer attention – the cybersecurity market is booming, forecast to grow at a compounded annual rate of 10.2% over the next decade. As the world becomes more and more reliant on technology, even this could turn out to be a bit conservative.

That said, the firm does not have as much of a competitive edge in cyber. Several other corporations specialise in cyber defence and have a far bigger footprint and more resources than BAE – Cisco Systems (Nasdaq: CSCO) for one. Still, at just under 10% of revenues in 2021, the cyber and intelligence division gives the group valuable diversification into a fast-growing sector.

Refinitiv analyst estimates have the stock earning 50.5p per share this year, suggesting the shares trade on a forward price/earnings (p/e) ratio of 15.3. That’s a bit on the high side compared to the group’s five-year average of 12, although considering BAE’s tailwinds and the uncertainty facing most other FTSE 100 groups, I don’t think the price is too high for a safe haven in stormy waters.

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