The launch of the aircraft carrier HMS Queen Elizabeth, the UK’s largest-ever warship, is significant in many respects. Not least it’s a showcase for the very best of British engineering, and there are some important takeaways for investors.
Firstly, it’s a reminder just how integral BAE Systems (LSE: BA) is to the UK’s defence capability. BAE is the lead contractor in the aircraft carrier alliance whose other industrial partners are Babcock (LSE: BAB) and Thales. BAE is effectively the UK’s national champion, and the only firm capable of delivering such a massive project: the final bill for the Queen Elizabeth and its sister ship the Prince of Wales will be some £6bn.
That underscores BAE’s defensive characteristics as a stock. The company may have reduced its reliance on UK defence spending, which is now about a fifth of BAE’s business, but the UK hasn’t reduced its reliance on BAE.
Money-spinner
But there’s a bigger lesson from the launch. The Queen Elizabeth will carry the F-35 fighter jet, the state-of-the-art multi-task fighter being developed for the Pentagon. BAE makes the F-35’s tail, and overall has a 17% share in the value of each aircraft. It has been a controversial programme, with cost and time overruns, but it now looks like it’s coming together – and will be a massive money-spinner for BAE as well as lead contractor Lockheed Martin.
The US is expected to buy 2,500 of the jets, with total sales expected to be above 3,000. Production will build up to a peak over the rest of the decade, and should continue for another ten years after that. The F-35 programme should account for about 10% of BAE’s revenues and profits over that time.
That’s a very solid chunk of earnings to have in the bag, at a time when Western defence spending is shrinking and BAE’s priority is to diversify. On a forward PE of 11 and yielding 4.9%, the shares looks cheap.
Earnings visibility
With a market cap of £5bn against BAE’s £13bn, Babcock is the lesser-known alliance partner, but it too has substantial defence interests. It is responsible for designing and building Britain’s nuclear submarines, as well as operating the Devonport and Clyde naval bases. It has a four-year order book, but its P/E of 16.9 (yielding 2.1%) means you have to pay for that earning visibility.
The Queen Elizabeth’s two gas turbines and two propellers are made by Rolls-Royce (LSE: RR). The scale of those components — the propeller is seven metres across whilst the turbines could power a town the size of Swindon — is in marked contrast to the aero engines Rolls-Royce is most known for. The sale of the company’s smaller gas turbine business and £1bn share buy-back plan has recently boosted the share price, but a PE of 15.6, yielding 2.3%, is reasonable.
Competitive advantages
All three companies have fantastic competitive advantages based on proprietary technologies and capabilities, with future earnings underpinned by multi-year order books. They necessarily plan long-term and build long-life products that generate service revenues. That’s quite an attraction for long-term investors.
