2023 was a good year for BAE Systems (LSE: BA) shares which rose almost 30%, while investors enjoyed a 2.43% dividend yield as well.
Shares in the FTSE 100 security and aerospace manufacturer have been going great guns for some time, up 144.07% in five years. That makes me sad for two reasons. Firstly, I don’t own them. Second, and more importantly, it’s a sign of the volatile world we live in.
Sadly, that doesn’t look like changing. Western countries have been stocking up after donating weapons to Ukraine. Defence order books are at record levels and could get even longer as Red Sea tensions escalate.
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A defensive stock market play
BAE Systems reported $10bn of new orders in Q3 and expects full-year 2023 underlying pre-tax earnings to rise 5-7% on last year’s £23.3bn. Order flow and the “opportunity pipeline” remain strong, and I can’t see that changing.
Defence is no longer about super-expensive fighter jets, warships and aircraft carriers. The Ukraine war has triggered a shift to cheap drone tech. Houthi rebels are harassing international shipping with $2k drones that US ships are shooting down with $2m missiles. That imbalance isn’t sustainable.
BAE Systems is now developing a disposable drone called Jackdaw with FTSE 250-listed defence and security manufacturer QinetiQ Group (LSE: QQ), which was spun out of the Ministry of Defence nearly 20 years ago.
The shift to cheaper, small-scale weaponry could threaten BAE’s profitability, but it seems unlikely. It’s more likely to open up a new area of demand.
BAE Systems’ shares could tank if Gaza tensions ease, Iran retreats from confrontation with the US, peace breaks out in Ukraine and Chinese Premier Xi Jinping dials down his Taiwan rhetoric. I can’t see it.
I may buy this instead
A bigger concern is that BAE Systems shares are expensive, trading at 20 times earnings, more than double the FTSE 100 average of 9.5 times. I’m wondering whether QinetiQ offers a better opportunity. It’s notably cheaper, trading at 11.66 times earnings, while yielding roughly the same at 2.49%. It also specialises in new weaponry like drones, military robots and electric tanks.
QinetiQ is securing its fair share of contract wins, including a five-year $170m deal with the US Department of Homeland Security for its TARS detection and tracking tech. This is supplied by Qinetiq’s Avantus unit, bought in November 2022.
Avantus is helping QinetiQ build a US presence. In 2023, it secured $827m of new contract awards, including a five-year $224m deal with the US Space Development Agency.
Yet the QinetiQ share price actually fell 15.11% last year. It even missed the year-end stock market rally. Investors may have been deterred by its patchy dividend record, and fears that it could be snapped up by a private equity marauder for a song, in line with other UK defence manufacturers like Cobham.
Yet with cash-strapped Western governments likely to switch focus to cheap, nimble defence tech, I think QinetiQ could grow faster than BAE Systems in 2024. I’d like to own both, but I’ll consider buying QinetiQ first.
