SAFRY - BAE Systems: Add To Watchlist But Don't Climb Aboard Yet

2023-09-21 14:41:04 ET

Summary

• For this quality company, a new buyer would need to pay a premium at its current valuation. Recommend add to watchlist and wait for a pullback.
• Compare to industry competitors, BAE Systems has superb margins.
• The company's Backlog order 3x's their market cap— creating a solid moat for years to come.

Editor's note: Seeking Alpha is proud to welcome Jack Campbell as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

Bottom Line Up Front

At a current price of $53, BAE Systems plc (BAESY) (BAESF) is 55% overvalued. However, this is not a recommended short, as the company's fundamentals are superb. Recommendation is add to BAE Systems to your watchlist and look for entry at $32-$34 price per share.

Introduction

For those who don't know, BAE Systems is a British Multinational Aerospace and Defense (A/D) Corporation which, according to its website, employs approximately 35,000 people across its major operations in the United States, United Kingdom, and Sweden, generating nearly $12.6 billion of sales in 2022. Unlike the American mainstay primes in the A/D Space, BAE Systems has deep market penetrations across both Europe and North America.

BAE Systems provides support and service solutions for current and future defense, intelligence, and civilian systems; designing, developing and manufacturing a wide range of electronic systems and subsystems for both military and commercial applications; produces specialized security and protection products; and designs, develops, produces, and provides service support of armored combat vehicles, artillery systems, and munitions.

Being one of the prime defense contractors across multiple of high barrier to entry segments, BAE Systems is extremely well postured for future growth. While certainly the rising tides of increased defense spending across western countries is raising most ships, if the winds turn, BAE Systems is poised to weather the storm.

Margins, Margins, Margins

Taking a snapshot of their financials, BAE Systems broadly performs in the top 25% of Gross, Operating and Net Margins of its Aerospace and Defense Pier Group. Furthermore, when compared to its past reports found here ; a 66.63% Gross Margin and 9.95% Operating Margin is performing in the top 5% of BAE Systems historical margins. Indicating management is efficiently managing Cost of Goods Sold (COGS), non-cash expenses and Selling, General and Administrative Expenses (SG&A) across the balance sheet.

See below how BAE Systems stacks up compared to its European competitors of Safran ( SAFRY ) and Rolls Royce PLC ( RYCEY ).

As you can see, of the main European competitors, BAE Systems has the lead with Gross Margin % by 1,800 basis points over Safran. This is complimented by being the only one with a Positive Net Margin— indicating top and bottom-line Margin efficiency. Chief Executive Charles Woodburn reiterated this in last year's annual review stating that "continued attention to operational excellence and financial discipline together provide a high level of visibility for sales growth, margin expansion, cash generation and capital returns over the coming years".

Return on Equity ((ROE)) and Return on invested Capital ((ROIC)) in terms of percentages have furthermore remained robust at 17.56% and 6.83% respectively, performing top of its peer group with RYCEY returning negative equity and SAFRY returning ROIC of 5.3% as reported end of June 2023.

See below for the ROE since Calendar Year ((CY)) 2014. Note: 17.56% is ROE for June 2023. 16.46% is from December 2022.

Backlog

While ~17 cents being returned in profit for every dollar of equity is certainly enticing, especially when compared to its European competitors, what's even more significant is the runway ahead of the company in terms of committed backlog orders.

In the yearend review for BAE Systems, Group Finance Director Brad Greve stated that the strong financial performance with top-line growth, margin expansion and high cash conversion was based on "our record order intake of £37bn increases our order backlog to £59bn, positioning us well for the future".

As a means of insulation from competition, nothing states having a solid moat more than backlog exceeding the current market capitalization of the firm. Let alone a backlog that nearly 3x the Market Capitalization. Please see below:

A 72.88% increase in Backlog Orders from £21.456bn to £58.9bn is no small accomplishment. It is important to recognize however, that there is spread load of these backlogs across the company's sectors.

As of Fiscal Year (FY) 2022, BAE Systems had an Order Backlog of £8.1bn for Electronic Systems, £8.1bn for Platforms and Systems, £24.4bn for Air, £17.2bn for Maritime and £2.1bn for Cyber & Intelligence.

The lynch pin for success, however, will be predicated on the execution of orders for the Air and Maritime Sectors. Key examples of this are found below:

Naval ship modernization and renewal are key contracts secured by BAE Systems as the U.S. Navy, along with Western allies seek to urgently bridge critical gaps found in their respective Navy's capabilities. These came in the form of a £1.0bn ($1.2bn) contract and a C4I Support Contact worth ($537m) .

Most significantly for the Air Sect, BAE Systems secured last June an 18 year, $12bn cap contact with the U.S. Air Force Intercontinental Ballistic Missile (ICBM) Minuteman III Project.

While not Air or Sea sectors, notable accomplishments come in the form of renewal across the ground platforms with the U.S. Army selecting the Beowulf for its Cold Weather All-Terrain Vehicle ((CATV)) programme to replace the Small Unit Support Vehicles, with a contract estimated to be worth up to £231m ($278m) for 110 vehicles .

Ball Aerospace Acquisition

It has been mentioned in other Seeking Alpha articles that BAE Systems is poised to acquire Ball Corp's Aerospace segment for $5.55Bn an all cash transaction. While the street has been generally neutral to slightly negative in response the acquisition, I believe it is an excellent long term play, adding depth to BAE Systems Cyber and Intelligence segment. As reported in the August 2023 Half Year report, the Cyber and Intelligence Segment saw margin reduction, due primarily expenses to grow the segment internally. The additions Ball Aerospace to BAE Systems space and multi-domain networking will greatly contribute to this segment and continue to diversify BAE Systems revenues.

Pricing

With robust backlog and being a large cap A/D company, BAE Systems has attention of Institutional Investors with Ownership coming in at ~85%, with the general public owning ~10% of all shares outstanding. See below:

From my experience when there is this high level of institutional investors— meaning funds and or companies with over $100m in market capitalization— frequently there are often stretched valuations of the companies they hold. This leads to my discussion of BAE Systems current intrinsic value. Which I have at $32-36 per share.

This is calculated primarily based on a modification of the Warren Buffett/Benjamin Graham valuation model of looking at historical multiples of Price to Earning (P/E), Price to Share (P/S) and Price to Book (P/B) ratios. Measuring these ratios against the five year medians; I use historical Discounted Free Cash Flow ((FCF)) to measure current valuation and project future valuation. See here for Seeking Alpha's valuation metric.

I see a broad overvaluation of BAE Systems when comparing current valuations to the historical five year medians— 5 year median given enough data for a Discounted FCF model— I will get into this more later.

The current P/E ratio is 17.2— compared to the company's five year median of 13.1, this is a 31.2% premium. P/S ratio is currently 1.48 compared to a median of 0.98— a 52% premium. P/B ratio is 3.02 versus median of 2.92— a 3% premium. Averaged out, we see a median premium value mark of 28.2% premium.

Discounted FCF calculation is below:

Valuation = (Growth Multiple) x FCF (5yr average) + 0.8 x Total Equity

Based on this formula, current intrinsic Discounted FCF is $35 a share.

Generally anything below 10x Price to FCF ratio is acceptable and considering the current ratio for BAE Systems is 1.5x the future valuation looks tasty. However, when making a recommendation I want significant downside protection to purchased share price, and currently I do not believe $35 Intrinsic Discounted FCF is supported. When looking in the rear view mirror median five year Discounted FCF is $18.10 per share, which has a 5 year Price to FCF ratio at 2.92x.

It's a double edge sword; current Discounted FCF is supported directly by improved Margin efficiency, however, I believe the Trailing Twelve Month improved cash flow is not enough of a justification for heightened intrinsic value. For this reason and the premiums on P/E, P/S and P/B, I believe the base valuation is $32-36 and is why I believe a purchase premium at this price would be 55%. For this reason, BAE Systems is currently recommended a watch.

Conclusion

It doesn't take much to identify that BAE Systems is well postured for the future. Even if all western governments slashed Defense spending for next year, the company has a built-in moat expanding decades of prepaid work. Furthermore, if in light of recent Russian invasion of Ukraine and tension surrounding Taiwan, you were of the bullish persuasion on the Defense sector such as myself, I believe there are few better places to hop in the Defense sector than with BAE Systems, just make sure it's at the right price.

For further details see: