BAE Systems is a global defence, aerospace and security company employing around 83,900 people worldwide. Their wide-ranging products and services cover air, land and sea.

They design, manufacture, upgrade, and support combat and trainer aircraft (air), combat vehicles (land) and ships (sea). They also develop a wide range of advanced technologies for the commercial and military electronics markets.

BAE is also a leading supplier of cyber, intelligence, and security capabilities to government agencies.

Investment Rationale

We reviewed our model on BAE Systems and maintain our Buy recommendation on the stock. Nonetheless, we reduced our price target to 710p from 780p. The reduction in price target is a result of a lower forward multiple that factors in additional risk brought about by Brexit negotiations. However, we remain optimistic about the future of the Group.

Governments in both the US and UK have prioritised defence and security spending and if they continue to do so then it could provide BAE Systems with opportunities to sustain or increase production in their two biggest markets.

Since President Trump was elected back in November 2016, BAE System shares have returned 18% (taking into account both capital gains and dividends).

Our base case scenario assumes that Governments will continue investing in defence and security with companies like BAE Systems benefitting from this.

The downside risk of a Company like BAE Systems is a reduction in the budget for spending on defence and security. However, we do not expect this to happen in the short to medium term.

Our valuation model assumes an operating margin by the end of 2018 in line to that of the year end 2017, which is in accordance with management guidelines. We are assuming constant margins due to the fact that 2018 is a transition year for the company as it is going through a restructuring phase to position itself for future growth.

The Air and Electronic Systems segments are the two segments that contribute most to operating margins. The Air segment is set to benefit by UK defence and security spending with the announcement of the UK Combat Air Strategy while the Electronic Systems segment is well positioned by products such as the award winning APKWS to maintain their long-standing customer positions and to compete for new business with its rivals. Should these two segments experience no surprises, and if a better performance is registered in the Maritime segment (as is expected by management), then margins are set to increase post 2018.

We are also seeing an increase in the group’s order backlog for H1 2018 from £38.7 to £39.7 billion, when compared to the same period in 2017, which means that demand for BAE Systems’ products has increased and should boost sales in the coming years.

With BAE Systems’ share price trading at 17% below our price target, we feel that this could be an attractive investment for those investors that are willing to hold the share for the medium term.

Valuation

* Our 12-month price target of 710.00p per share assumes a discount rate of 10% and a forward P/E multiple of 24x.

* Revenue – We expect revenue growth of 0%, 5% and 5% in 2018, 2019 and 2020 respectively. No growth is expected in 2018 due to the transition phase BAE systems is undergoing, however, we do not expect BAE Systems to record lower revenues at the year end when compared to 2017 either. We believe that the benefits of this transition phase will be realised in both 2019 and 2020.

* Operating Margins – We expect operating margins of 9.45%, 9.62% and 9.79% in 2018, 2019 and 2020 respectively. We expect margin improvements to come from improved efficiency after the restructuring phase is over this year.

* Earnings per share – we are assuming an EPS figure of 28p, 31p and 33p in 2018, 2019 and 2020 respectively.

This article was issued by Kristian Camenzuli, investment manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.