Over the past 12 months, shares in BAE Systems (LSE: BA) have slipped nearly 9%, excluding dividends, underperforming the FTSE 100 by several percentage points.
However, I believe this weakness is temporary and the shares are set for a near-term recovery as the group reinforces its position in the global defence market.
Market performance
BAE’s performance over the past year is disappointing, but the firm’s long-term record of value creation is more impressive. Indeed over the past three years, the stock has returned 10.8% per annum, including dividends, outperforming the FTSE 100 by 3% a year. It’s also registered a similar performance over the past five years.
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The recent underperformance has taken shares in BAE back to where they were at the end of 2017, suggesting the market is ignoring the City’s 2018 growth projections. Analysts have pencilled in earnings per share (EPS) gains of 18% for 2018, followed by an expansion of 9.2% for 2019. These figures suggest the stock is trading at an undemanding forward P/E of 12.7, falling to 11.6 for 2019.
That said, the City’s numbers clash with BAE’s own growth estimates. Back at the beginning of August, management told investors to expect flat earnings this year, after winning a $26bn contract to build warships for Australia.
Last year, the company reported normalised EPS of 36.4p. Based on this figure, the stock is trading at a forward P/E of 15.1.
Best in the sector
A P/E of 15.1 is not too expensive for an international business with a steady order book, in my view. On top of the attractive valuation, the stock also supports a market-beating dividend yield of 4.2% on a forward basis.
What’s more, BAE’s valuation is below the defence sector average. Peer Chemring (LSE: CHG) trades at a dearer 16.6 times forward earnings, and has a more mixed-growth outlook.
After a troubled few years, beset by contract delays and restructuring efforts, analysts had expected the business to return to growth in 2018. Unfortunately, a fatal explosion at its Salisbury factory in August wrote off this expectation. Now, due to lost production and clean-up costs, EPS are projected to fall nearly 40% year-on-year. However, EPS are expected to rebound in 2019 — barring any unforeseen developments. The City is forecasting EPS of 11.7p for 2019, giving a 2019 P/E of 16.5.
If I had to choose between these two sector peers, I would buy BAE for my portfolio over Chemring. Not only is Chemring more expensive, but the company’s business is unpredictable. Sales at the group have actually fallen by half over the past five years.
BAE offers a much more stable growth platform with its multi-billion dollar international projects. Further, the shares are deeply undervalued compared to the rest of the global defence industry. Shares in US peer General Dynamics, for example, change hands for 18 times forward earnings.
On this basis, I rate BAE shares a ‘buy’ as I think they’re due a near-term recovery.
