BAE Systems offers more promise than profit in the short term

The instant reaction from investors to BAE Systems’ (BA.) financial statements was one of deflation, with the shares falling by 3 per cent in early trading before ending the day flat.

The defence giant has been one of the FTSE 100’s strongest performers over the past year, with its share price gaining by 50 per cent as investors expected it to be a beneficiary of increased defence spending following Russia’s invasion of Ukraine. 

This isn’t an unreasonable assumption to make, although the £37bn of new orders last year (swelling its backlog to £58.9bn) is largely the result of work won on existing programmes, chief executive Charles Woodburn told investors.

Revenue growth was fairly muted at 4 per cent to £21.3bn last year, and operating profit was flat at £2.38bn, albeit marginally ahead of guidance. 

The company pointed to higher capex, which more than doubled to £519mn, and increased R&D spend as factors as it gears up to meet long-term demand. Free cash flow, at £1.95bn, was around £700mn higher than consensus estimates, but this is largely a pull-forward from the current year, with the company guiding for a decline to around £1.2bn this year. 

It was the forward guidance on profit that proved most underwhelming, though. BAE Systems forecast underlying operating profit growth of between 4 and 6 per cent, which was below consensus forecasts of 7 per cent. Although margins are expected to increase in both its Air and Platforms & Services divisions, higher research and development (R&D) spending will squeeze returns in its cyber and intelligence arm, analysts at Berenberg said.

Given the muted outlook on earnings for this year and the gains made in its share price over the past 12 months, a desire to cash in and bank gains would be understandable. Yet the real benefit of higher defence spending is yet to come. Woodburn argued that it typically takes 18 months before orders feed into sales, and that a “material step-up” in revenue growth is expected from next year. 

In the meantime, shareholders can benefit from a 7.6 per cent increase in the dividend and the fact that BAE is still only halfway through its three-year, £1.5bn buyback programme. And at 15 times forecast earnings, its shares are cheaper than most of its global peers. We maintain our buy stance. 

Last IC View: Buy, 785.8p. 28 Jul 2022