The noise being made by fund managers about environmental, social and governance investment tells you that sin stocks should be being punished. But there’s more to the lowly valuation attached to BAE Systems, the giant defence comoany, than squeamishness.
BAE is more cheaply valued than all but one of its international peers in the defence sector, with a forward enterprise value of just under eight times ebitda — earnings before interest, taxes, depreciation and amortization — and a price/earnings ratio of 12.
A pricier American stock market accounts for only part of that discount. The FTSE 100 constituent has been trying to shake off concerns over the reliability of its cashflow. Onerous contracts, cost overruns and towering pension liabilities have cast a shadow over the stock in the eyes of investors.
Yet a £1 billion payment into the UK defined-benefit pension fund last year helped to diminish the shadow of the deficit, which for more than a decade had swallowed cash as the group made successive contributions to plug the gap. It reckons that monster payment will be its last and that the deficit will hit zero by 2026. That’s not only good for the credit rating but also means there’s more firepower to invest in research and development and mergers and acquisition activity. Management has set a three-year free cashflow goal of £4 billion out to 2023, up from the £3 billion target between 2019 and this year.
It also stands to make BAE improve in the estimations of dividend-obsessed investors. On that score, those that have bought into the company were vindicated last month by a 5 per cent rise in the interim dividend and the launch of a £500 million share buyback programme. Based upon dividend payments alone, potential cash in the back pocket looks pretty good for investors. A full-year dividend of 24.59p a share is forecast by the market this year, which at the present share price of 578½p would leave the stock offering a potential yield of 4.3 per cent.
The magnitude of some of BAE’s development contracts (think shipbuilding or developing submarines) means there is still the potential for costs to overrun. They also typically involve large advance payments, which has meant lumpy cashflows year-to-year.
Yet while big-ticket deals such as the recent contract to produce 38 Typhoon aircraft for the German air force grab attention, BAE is trying to push into areas including technological development, where contract payments are smaller but more frequent. Its electronic systems division, which develops products such as commercial digital engine and flight controls and navigation systems, accounted for just over a fifth of revenue in the first half.
Growing revenues internationally is also a target. Sales to the United States accounted for more than 40 per cent of revenues over the first half. It’s growing in Europe and Australia, too, but diversification could be a double-edged sword. Revenue derived from European countries, which generally have spent less on defence than America and Britain, has been more lowly rated by the market, according to Rory Smith, of Investec.
There’s no getting away from wider political risk, either. BAE provides defence equipment, training and support under government-to- government agreements between Britain and Saudi Arabia, which accounts for 13 per cent of revenue. That’s lower than it has been historically, but the potential removal of export licences is always a risk.
While unpalatable to some, the lure of vice stocks to others is often a cheap share price and generous dividends. BAE offers both.
ADVICE Hold
WHY For those with the stomach, the shares offer a solid dividend for a low price
Hill & Smith
For a FTSE 250 constituent, Hill & Smith is pretty esoteric, but that’s the way it seems to like things. The industrial group targets niche markets, such as producing reinforced fencing for data centres, as well as the more broad design, manufacture and supply of permanent road safety barriers and technology-supported road message signs.
The idea is that by specialising in areas that larger groups might not bother with, it can craft a better margin. So far it’s managed to prevent its margin being derailed by higher raw materials and staff costs, passing inflationary pressures to customers via price increases. Thus the underlying operating margin snuck just back within management’s target range during the first half of this year, at 12 per cent.
Together with a recovery in demand in Britain and internationally, it meant that the company raised its guidance for underlying operating profits this year ahead of the top of the present analysts’ forecast range, which stands at £84.6 million.
Peel Hunt, the broker, raised its adjusted pre-tax profits and EPS targets for this year by 3 per cent to £77.4 million and 75.8p, respectively.
Yet despite its exposure to more stable government spending, the group’s core roads and security business was hurt by the pandemic. It sank to an operating loss during the first half, because of one-off items that included a £10.8 million impairment charge taken against its ATG Access business, which makes and distributes hostile vehicle barriers. A lack of large events and cuts in spending hindered the group’s prospects.
Prioritising margins also meant dropping about 80 per cent of the acquisitions pipeline in November. Targets need to have the potential to generate a gross margin of at least 40 per cent, but also the ability to pay their way over the longer term rather than providing a short-term boost to earnings, according to Paul Simmons, the chief executive.
The shares rose by about 9 per cent, or 150p, to £18.12 on the back of the interim results, but that still leaves its valuation trailing peers. It’s got the potential to play catch-up.
ADVICE Buy
WHY Potential to benefit from growing infrastructure spending in the UK
