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Questor: the Saudi factor has held BAE Systems back but is becoming less significant – time to buy
Questor share tip: the defence company's drive to sell more to countries such as Australia is reducing its dependence on riskier markets
Britain's largest defence company, BAE Systems, could be a major beneficiary of the Conservatives’ general election victory.
It may not have been a specific nationalisation target for Labour, but a pacifist prime minister such as Jeremy Corbyn could easily have reversed plans to renew Britain’s nuclear deterrent.
This would have hurt BAE because it makes the submarines that carry Trident nuclear missiles. Its maritime products, as well as an array of air, cyber and land-based military assets, are sold across the world’s major defence markets.
They include America, which is the world’s biggest spender on defence and accounts for 42pc of the company’s sales. Following a long series of cuts after the financial crisis, the US increased military spending by 7pc in 2018, its fastest rate of growth in a decade.
Future increases in US defence spending are expected to be mirrored across Nato. A fiscal stance dominated by austerity is gradually being relaxed and the alliance’s members have agreed to move towards spending 2pc of their GDP on defence by 2024; this year only nine of the 29 members met that target.
As a result, the defence industry could experience a prolonged tailwind as countries such as France, Germany and Italy seek to fulfil their military spending obligations.
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This column thinks the industry’s growth prospects could also be supported by an improving outlook for the world economy. According to the IMF, global growth is expected to be 0.4 percentage points higher in 2020 than this year.
It’s true that Brexit-related risks could hold back economic performance in Britain and continental Europe in 2020. However, BAE’s modest level of trade with EU nations should help to limit the risks. This relative lack of exposure may be increasingly valued by investors concerned at the prospect of a no-deal Brexit at the end of the transition period in 12 months’ time.
Currently, the company is ramping up production as it seeks to deliver on a record order backlog that grew by 25pc in 2018.
Its recent results highlighted its success in winning new contracts across a wide range of products and services, while an organisational restructuring implemented last year, which included senior management changes, is improving its efficiency and competitiveness.
BAE is also seeking to diversify the range of markets in which it operates. For example, it expects its Australian business to double over the next five years following the award of a contract in 2018 for the design and construction of nine ships.
This could help to reduce its reliance on major defence markets such as Saudi Arabia. The kingdom accounted for 14pc of the company’s revenue last year and faces ongoing geopolitical risks that could affect BAE’s ability to service demand for its products and services.
Questor views this threat as responsible for the stock’s lacklustre performance since our “sell” advice three years ago.
Since then the company’s shares have declined by 3pc, leaving them trading at a price-to-earnings ratio of 13.5 and yielding 3.9pc. Dividends have risen in each of the past 15 financial years.
Continued profit and dividend growth should be driven by rising demand for BAE’s products and services. The company’s competitive advantage across a wide range of markets should enable it to further increase its order book.
It is likely to find this task much easier following a general election result that avoids a significant change to British defence policy. The company’s share price should gradually begin to reflect this key development, as well as the potential for a growing commitment to defence spending across Nato and emerging economies.
Questor says: buy
Ticker: BA.
Share price at close: 566.8p
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