According to the Book of Isaiah, there will come a time when nations will beat their swords into ploughshares. However if you don’t believe that is going to happen within your investment horizon, then that’s pretty much the investment case for BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US).
Austerity-driven cuts in defence spending in the US and UK have dominated BAE’s prospects. Despite some diversification into cyber security — and absent a transformational deal like merging with EADS — they will continue to do so. The US and UK together account for two-thirds of BAE’s sales. With another US budget ceiling approaching and a UK general election in 2015, budgets could get tighter still.
Adapt and survive
But the recent warning from former US defence secretary Robert Gates, that the UK’s cutbacks on military spending will undermine the country’s global standing, is perhaps a reminder that defence cuts are cyclical rather than secular. The tensions between Japan and China in the East China Sea, China’s massive military spending on aircraft carriers, nuclear submarines, drones and the like, and President Obama’s commitment to Asian security, tells you all you need to know about the eventual trajectory of US defence spending. A Congressional Committee has described China as ‘the largest challenge to America’s supply chain’.
Meanwhile, BAE has adapted well to constrained Western military spending. Cost-cutting, providing servicing and supplies, and the long-term nature of most defence contracts have mitigated the downside.
Setbacks
BAE’s sales into non-Nato markets have suffered setbacks lately. Negotiations to sell Typhoon fighter aircraft to the UAE broke down last month, about the same time the company announced that it was still haggling over terms of a contract extension with Saudi Arabia. 6-7p per share (15%) of consensus earnings for 2013 were riding on the successful conclusion of talks before BAE reports: news on that has gone quiet, and time is running out before BAE announces preliminary results next month.
Longer-term, BAE’s 17% share in the US’s next generation of fighter aircraft, the F-35, should reap rewards. The Pentagon has largely protected that programme from budget cuts, though it has been criticised for over-spending and more of the contract risk could fall on the suppliers in future.
Yield
So there’s plenty of scope for near-term volatility in BAE’s shares, but its core business looks sound. The shares have struggled since last November, after a strong run, and uncertainty over contracts could dog them further. But a healthy 4.6% yield, decently covered by earnings and cash, is the main reason to hold them.
