Is Now The Right Time To Sell BAE Systems plc?

Should investors be alarmed by falling sales and profits at BAE Systems plc (LON:BA)?

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baeDefence giant BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) is a core element of many investors’ income portfolios — including my own.

The firm’s share price performance has matched that of the FTSE 100 over the last five years, climbing by around 45%, but BAE’s high yield has helped the defence giant beat the index, with BAE delivering an average total return (capital gains plus dividends) of 11.9% per year, compared to 11.1% for the FTSE 100.

However, BAE’s dividend could be losing its shine: the firm is only expected to increase its payout by 1.4% this year, and by 2.4% next year.

Problems?

Let’s start with the basics: how is BAE valued against its historic and forecast performance?

P/E ratio

Current value

P/E using 5-year average adjusted earnings per share

11.1

2-year average forecast P/E

12.0

Source: Company reports, consensus forecasts

On the face of it, BAE looks very reasonably priced, especially given its 4.4% prospective yield.

However, BAE has been struggling to grow in recent years, thanks mainly to budget cutbacks in the UK and US — the firm’s two biggest markets.

Is BAE cheap because it’s a business that’s stagnating — or shrinking?

Fundamental shrinkage

A closer look at BAE’s accounts from the last five years suggests that BAE’s business may indeed be shrinking slightly:

5-year compound average growth rate

Value

Sales

-3.6%

Underlying earnings

-2.6%

Underlying earnings per share

1.4%

Dividend

+4.7%

Source: Company reports

Annual turnover has fallen by an average of 3.6% per year since 2009, while underlying earnings (defined by the firm as earnings before interest, taxation and amortisation, or EBITA), have fallen by an average of 2.6% per year over the same period.

Investors have been consoled with dividend growth averaging 4.7% per year, but the apparent annual growth in the firm’s underlying earnings per share should be treated with caution: it contradicts BAE’s falling profits, and is mainly the result of the company’s ongoing share buyback programme, which totalled £212m in 2013 alone.

Uncertain outlook

I don’t think BAE’s problems are bad enough to warrant selling the stock, but I only rate it as a hold at present, not a buy.

One of my concerns is that City consensus forecasts for the firm’s earnings have been downgraded steadily this year: the current forecast, for earnings per share of 37.6p in 2014, is almost 5% lower than it was just three months ago.

In my view, BAE’s shrinking sales and profits are a warning that the current share price might not be as cheap as it seems. I believe it might pay to wait a little longer, before buying any more of the firm’s shares.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares in BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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