BAE Systems plc (BA.) Ordinary 2.5p

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In a short trading update, BAE Systems confirmed that its integration of the Space & Missions Systems (SMS) business is “progressing well”. Sales are ramping up over the second half, and cost cuts are helping to improve profitability. Over the medium term, the group hopes to grow SMS sales by 10% annually.

Around £25bn of orders have been booked year-to-date. The workforce has grown by around 7,500 employees to help meet the workload.

Full-year guidance has been reiterated. Sales and underlying operating profit are expected to grow 12-14%, with free cash flow above £1.5bn.

The shares rose 1.2% in early trading.

Our view

BAE Systems’ short trading update showed its integration of the Space & Missions Systems business (formerly Ball Aerospace) is continuing as expected. With sales and profitability in this division improving, full-year guidance remains on track.

Back to the main story, BAE Systems manufactures heavy-duty military equipment like fighter jets, aircraft and submarines, and recent global events have increased demand for its products.

Despite being a UK-based company, a whopping 45% of its sales came from the US in the first half, making it the largest single contributing region. On an absolute basis, US military spending trumps any other country in the world, so having large exposure to this market is proving very beneficial.

But BAE hasn’t stopped there. It sealed the deal on its £4.4bn acquisition of US-based Ball Aerospace in February, which is increasing its foothold on that side of the pond. Ball has unique in-space capabilities, which is seen as a major growth area in the defence industry. The integration is progressing well and should help drive top-line and margin growth, although nothing is guaranteed.

Demand for the group’s products and services remains strong as the group booked around £25bn of orders over the year to 12 November. And because these are typically long-cycle orders, with revenues spread over several years, it gives BAE multi-year revenue visibility. That’s an enviable asset to have and helps underpin a prospective dividend yield of 2.5%. Please remember no dividend is ever guaranteed.

But keep in mind that profitability hinges on an ability to estimate future costs. The long-term nature of many contracts means that the related risks and costs can change over time. Currently, its turbulent energy costs and potential supply chain issues that management has called out are the main trip hazards.

Despite the rise in debt to help fund the Ball acquisition, we’re happy with the balance sheet. BAE has a strong demand outlook and plenty of free cash flow pumping around the business to manage these debt payments. However, it does mean we could see the rate of share buybacks slow in the near to medium term though no shareholder returns are guaranteed.

We think BAE's in good shape to deliver on its long-term growth strategy. Despite its valuation being well above the long-run average, it still trades at a significant discount to its US peers, which we view as unjustified. Operational and supply chain challenges will be difficult to navigate, so some ups and downs can’t be ruled out.

Environmental, social and governance (ESG) risk

The aerospace and defence sector is high-risk in terms of ESG. Product governance and business ethics are key risk drivers. Carbon emissions from products and services, data privacy and security and labour relations are also contributors to ESG risk.

According to Sustainalytics, BAE System’s management of ESG risk is strong.

It has a product safety policy and chain of accountability and assesses safety throughout product development. It has a board-level committee that oversees business ethics risks and has improved disclosure regarding human rights. However, disclosure regarding quality management standards and external certifications are lacking, and BAE should improve reporting on business ethics incident investigations. Employee development programmes are strong and the group has committed to net zero with interim targets in place.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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