2023-12-12 17:55:11 ET
Summary
- BAE Systems stock has outperformed the market and peers, with a surge of 31.5% since December 2022.
- The company has seen strong growth in key metrics, including a 17% increase in order growth and a 14% increase in sales growth.
- BAE Systems has increased its guidance for 2023, with sales expected to grow between 5-7% and underlying EBIT expected to grow between 6-8%.
Last year I initiated coverage for BAE Systems plc ( OTCPK:BAESF , OTCPK:BAESY ) and pointed out that there was a major focus on the US Defense contractors, but there were companies in other geographical areas that are able to benefit from the same growth drivers. In this report, I will be discussing whether the buy rating for BAE Systems has worked out, what the current results look like, and what price target I am attaching to BAE Systems using my updated stock valuation tool.
BAE Systems Outperforms The Market And Peers
Since my report published on December 1, 2022, BAE Systems stock surged 31.5% with a total return of 35% compared to the S&P 500 returning roughly 13.3%. I have stacked the performance against Lockheed Martin Corporation ( LMT ) and Northrop Grumman Corporation ( NOC ) and the performance fully supports my view expressed last year that investors might be looking in the wrong names to see their portfolio value appreciate.
BAE Systems Sees Strong Growth On Key Metrics
What I pointed out last year is that analysts were using book-to-bill ratios in combination with a generic bullish defense thesis to support a buy rating on defense companies. I also pointed out that if that is the golden standard for assigning buy ratings, then BAE Systems should have been higher on the list. Over the course of the year, the book-to-bill ratio has improved with £21.1 billion in order inflow and £12 billion in sales indicating a 1.76x book-to-bill ratio with order growth of 17% and sales growth of 14%. So, year-over-year we saw a modest increase in book-to-bill ratio from 1.69x to 1.76x. EBIT grew 13% in line with sales growth while free cash flow improved significantly from £123 million to £1.07 billion.
BAE Systems sales grew 14% and 11% on a constant currency basis. ES (Electronics Systems) sales grew 8% on constant currency. Similar growth rates were observed for Air and C&I (Cyber and Intelligence). P&S (Platform & Services) sales grew double digits at 11% while Maritime sales even grew 21%. So, across all segments, we saw very appreciable growth in revenues.
ES saw margins decline somewhat as its EBIT growth of 4%/9% fell short of the 8%/13% sales growth. C&I even saw its earnings decline as 7%/10% sales growth did not stack favorably and resulted in 22%/ 24% lower earnings due to additional investments in space and multi-domain networking. Platform & Services saw EBIT growth of 14%/18%, which was in excess of revenue growth, driven by better operational performance. Air posted the most impressive EBIT growth of 23%/25% as operational efficiency improved and risk was retired. Maritime earnings grew 6% falling behind the 21% sales growth. This was driven by fixed-margin Dreadnought sales.
BAE Systems Increases Guidance For 2023
For 2023, sales are now expected to grow between 5-7% compared to 3-5% guided for previously. Underlying EBIT is now expected to grow between s6-8% against a previous growth of 4-6% expected. Earnings per share are now expected to grow 10-12% compared to 5-7% percent growth expected previously. So, we see the positive translation of top line growth to earnings per share and the free cash flow of over £1.8 billion also compares favorably to the +£1.2 billion guide previously issued.
For what it is worth, BAE Systems increased its three-year FCF guidance by £500 million. The company expects FY2023 free cash flow of over £1.8 billion after generating £1.07 billion in cash flow in H1 2023. Looking at the previous, we do know that BAE Systems has tended to be conservative with its guidance, but it seems to be a reality that 2023 and 2024 free cash flow will be softer. That also provides some reason for BAE Systems acquiring Ball Corporation ( BALL ).
What Is BAE Systems Stock Worth?
Putting a price target on stocks is always a tricky endeavor. Stocks might be undervalued against peer valuations but overvalued against median company multiples and that is the case for BAE Systems. Against its own EV/EBITDA median, the stock is overvalued by around 17% but against the median peer group, there is a 50% upside. BAE Systems does face some challenges in consistently producing free cash flow growth, but I do not believe that the 8.8x median EV/EBITDA is justified given the strong order intake as well as the long-term visibility in multi-decade programs. Perhaps a 16x valuation in line with peers might be a bit steep due to challenges to generate consistent free cash flow growth in the years to come, but I do believe that a valuation right in between the peer group and the company median is reasonable putting the upside for BAE Systems at 16.5% putting the price target at $61.70 for BAESY and $15.30 for BAESF.
Conclusion: BAE Systems Could Be A Strong Addition To Your Portfolio
Last year, I pointed out that BAE Systems was not a strong buy in my book due to the soft free cash flow guidance and the fluctuations that can be expected in the years ahead. However, the buy rating has done quite well, and I am maintaining that buy rating as I believe that the company will have reasonable free cash flow generation, and I am a fan of the exposure to various multi-decade programs which are in different phases of the value extraction process and BAE Systems, like many other defense contractors, is active in an industry that is firmly supported by stronger defense budgets for years to come.
For further details see:
BAE Systems Performance Makes Lockheed Martin Look Small