Words such as ‘compelling’, and ‘undemanding’, are often over used by financial journalists, but in the case of defence giant BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), I believe they do make sense.
My particular favourite, in BAE’s case, is undemanding. There is simply no other way to describe this company’s valuation, as I’ll explain.
1. 10.7
BAE currently trades on forecast P/E of less than 11, based on current consensus forecasts for earnings per share (eps) of 39p in 2014.
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Although this is slightly down on last year’s underlying earnings of 42p per share, I don’t see this is a structural decline, which would justify a low P/E rating. In my view, the slight fall expected this year is simply a temporary weakness.
BAE’s cash flow and profits can be quite lumpy, due to the large size and duration of some of its contracts, but the firm’s order backlog remained stable last year, suggesting that long-term prospects are consistent with recent performance.
2. 5.0%
BAE’s main appeal is income. The defence firm’s shares currently offer a 5% prospective yield, and the payout is expected to rise slightly above inflation over the next couple of years.
BAE’s payout should be covered nearly two times by earnings this year, and although BAE’s income prospects are no longer quite so enticing as in 2012, when a yield in excess of 6% was available, the shares remain a strong income buy, in my view.
3. £699m
At the end of 2013, BAE’s net debt was just £699m, thanks to the firm’s £2.2bn cash pile.
This means that BAE’s net gearing is just 20% — far lower than most FTSE 100 companies, except the oil majors.
Although BAE could afford to service higher levels of debt, I believe that it is good discipline for slow-growing firms — such as BAE — to minimise debt levels and operate using their own cash flow and retained earnings, with surplus cash to fund dividends, rather than interest payments.
A ‘compelling’ buy
Unless you have an ethical objection to investing in defence firms, I believe BAE Systems is a compelling buy for income investors, thanks to its long-term outlook and high yield.
BAE publishes its half-yearly results on 31 July — I don’t expect any surprises, but the firm’s share price, which is down by 10% on last September’s peak, could respond well if results are better than expected.
