Late last week, we had some big news from FTSE 100 defence specialist BAE Systems(LSE: BA). The group announced that it had beaten rivals from Spain and Italy to land a massive £20bn contract to build nine anti-submarine warfare frigates for the Australian navy, with production expected to commence in early 2020 in South Australia. The market clearly liked the news as BAE Systems' share price jumped nearly 3% on the announcement.
A £20bn contract is no doubt a big deal for the company. Does the news make the stock a 'buy'? Let's examine the investment case.
There's a lot to like about BAE Systems from an investment perspective, in my view. For starters, I'm bullish on the defence sector. With geopolitical uncertainty across the world showing no signs of abating, I believe spending on defence is likely to remain robust in the medium term. I don't think countries can afford to cut back on defence with political tension remaining so high. The US certainly isn't holding back, with lawmakers recently passing a huge $675bn defence spending bill for fiscal 2019. Given that BAE Systems generates a large proportion of its sales from the US, the group looks well placed to grow its sales and earnings going forward. The £20bn contract win last week shows that the FTSE 100 company is viewed as a world-class defence contractor.
BAE Systems' valuation also looks quite attractive. City analysts expect the group to generate earnings per share of 43.3p this year which, at the current share price, places the stock on a forward-looking P/E of 14.8. I think that's a fair price to pay for a slice of the company when you consider that the FTSE 100 index is at a relatively high level right now. It's also worth noting that BAE Systems sports quite a healthy dividend yield at present, which adds appeal to the investment case. Analysts expect a dividend payout of 22.4p per share this year, which translates to a prospective yield of 3.5%. Dividend coverage is healthy and the company has an excellent track record of increasing its dividend over time, too.
Naturally, there are risks to the investment case. One is BAE Systems' pension deficit, which stands at around £4bn. A large pension deficit is a risk because the debt has to be serviced by the company, consuming cash flow. This year, it will have to direct £220m cash towards the deficit in an attempt to plug the gap. Profitability could also be affected if global defence spending was to decline.
However overall, I believe the outlook for BAE Systems looks promising. The shares have performed well so far this year, outperforming the FTSE 100, yet I think they have the potential to keep rising.
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Edward Sheldon owns shares in BAE Systems. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.