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BAE Systems is ready for action in an uncertain world

The Times

President Putin has been kind to BAE Systems. When the first Russian boot trod Ukrainian soil on February 22 last year, the armaments company’s shares were changing hands for 600p. They reached £10.32 this April, having been tipped here at 724p a week after hostilities began and at 821p last October.

However, in the past eight weeks they have suffered their first real setback since the pandemic, sinking by 104p to 928p before recovering a little. All seasoned military opinion suggests the conflict has some way to run, possibly years, and Nato countries are becoming emboldened to send Ukraine the sort of increasingly sophisticated hardware and ammunition that are BAE specialities. So why the doubts?

The group employs 93,000 people in 40 countries, providing some of the world’s most advanced technology-led defence, aerospace and security solutions, from armoured vehicles to combat ships, machine guns to drones, radar and flight control systems to cyber technology. It may restart production of the M777 howitzer, an artillery piece that has become a Ukrainian workhorse.

Within days of the first shells landing, the foreign secretary at that time, one Liz Truss, said Britain needed to increase defence spending and could not ignore the demand for conventional weapons, reversing years of shrinking defence budgets. Jefferies, the broker, said: “The move to 2 per cent of GDP on defence could trigger a 25 per cent growth in non-US Nato members’ budgets, which may translate into as much as a 40 per cent to 50 per cent growth in procurement spend over the next five years.”

Last month Charles Woodburn, BAE’s chief executive, said: “Trading so far this year has been in line with expectations, with continued good operational performance. Order flow on new programmes, renewals and progress on our opportunity pipeline remains strong.” He reiterated guidance of group sales up 3 per cent to 5 per cent, underlying earnings before interest and tax up 4 per cent to 6 per cent, underlying earnings per share up 5 per cent to 7 per cent and more than £1.2 billion of free cashflow.

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Yet there are also uncertainties about how far defence spending will rise, particularly in Britain, given its economic headwinds and government priorities to curb inflation and reduce taxes, in that order.

BAE has its own problems. As it reports in sterling, it is exposed to exchange-rate fluctuations against the US dollar and other currencies. And at the end of last year the company had £5.1 billion of long-term debt, up from £4.6 billion the year before, further exposing it to interest rate rises. The operating margin decreased from 12.2 per cent in 2021 to 11.2 per cent in 2022 and return on equity fell from 23.6 per cent two years ago to 14.1 per cent last year. However, the order backlog had risen to £58.9 billion by the start of this year, 2.52 times annual sales.

Morgan Stanley recently initiated coverage of the company with an “overweight” rating and £12.08 price target, adding that BAE was its top pick in the armaments industry. “We believe the group is in the early phase of a multi-year upturn, driven by strong and consistent programme execution, rising global defence spending and diverse positions on key growth programmes,” it said. “The group has an attractive shareholder returns policy, with a dividend yielding 3 per cent and an ongoing share buyback programme, which we think could be extended.”

The shares are trading at 16.4 times the lower end of Woodburn’s earnings guidance for the present year. Morgan Stanley’s projections would take that to 12.82 for 2025.

ADVICE Buy

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WHY A solid performer with more tailwinds than headwinds amid the clouds of war

Capita

Capita seems to be suffering from a credibility gap. When the technical services provider announced what it called “a step change in profitability” three months ago, the shares jumped from 29p to 42p in two days. Since then they have slipped back to about 31p, as if investors simply do not believe the recovery is real.

The company has the ambitious aim of “delivering innovative solutions to transform and simplify the connections between businesses and customers, governments and citizens”. In practice, that means the less-then-popular tasks of collecting the London congestion charge and the BBC licence fee, as well as staffing private businesses’ customer call centres.

Last August this column recommended merely holding the shares at 25p, because the recession that was threatening at the time might knock the company off balance.

Capita consists of three divisions: “public service”, serving central and local government; “experience”, selling telephone technology and debt management services to industry; and “portfolio”, a collection of businesses for sale. Last week it signed a £50 million deal with City of London police to help fraud victims.

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Its services are outsourced by customers largely because they are too complex to keep in-house. That was underlined this year by two data breach incidents: the first was a ransomware attack, giving the villains nine days’ access to steal bank account details, physical addresses and passport scans; the second involved a breach of 655 gigabytes of data in 3,000 files.

That risk exposure is reflected in the cautious share rating. However, Robin Speakman, at Shore Capital, does “see light at the end of the tunnel for Capita. We see a still-challenging environment for the group, reflected in the current year price/earnings ratio of 9.6.” He argues, too, that the recent sale of five portfolio businesses took the group nearer to completing its restructuring programme and the restoration of the balance sheet.

While many uncertainties surrounding Capita are fading, it may be some months before the share price catches up. Nevertheless, it is worth getting in ahead of the herd.

ADVICE Buy

WHY Capita is beginning to look beyond the recession threat

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