Can BAE Systems maintain its momentum?

Few UK stocks have epitomised investors’ apparent belief in a changing world order better than BAE Systems (LON:BA.).

For many years, this FTSE 100 defence group was a modestly valued, slow-growing but reliable dividend stalwart. That all changed when Russia invaded Ukraine in 2022.

The stock surged upwards again in February 2025, after US Vice President JD Vance gave a fiery speech to European leaders that raised questions about whether the US would remain a reliable ally in European affairs.

Even an investor who bought after the start of the Ukraine war could now be sitting on a double bagger, with further gains from dividends.

However, BAE’s valuation is elevated by historical standards. Meanwhile, the group’s heavy exposure to the US market – which contributed 48% of revenue last year – may be less of a clear-cut advantage than it once was.

I’ve been taking a fresh look at this leading global defence group. Is it time for investors to consider taking some profits on BAE? Or are we just at the start of a structural shift in growth and profitability for this FTSE heavyweight?

Summary

Pros:

• Record order backlog, potentially nine years’ including foreseeable pipeline;

• Rising defence spending in Europe, clear commitment by UK government;

• 30-year plus record of dividend growth, solid fundamentals, valuation is not outrageous given recent growth rate.

Cons

• US defence spending outlook is unclear; North America represented nearly half group sales in 2024;

• Risk that investment in major expansion could lead to a period of subdued returns

• Valuation is well above historic norms.

Profile

About the stock

BAE Systems provides advanced, technology-led defense, aerospace, and security solutions. It’s listed in the Industrials sector, within the Aerospace & Defense industry group.

The shares are listed on London’s Main Market, where the company is a member of the FTSE 100 with a market cap of £46bn and a recent share price of 1,500p.

The StockRanks reflect BAE’s elevated share price and solid financial performance, with a High Flyer styling reflecting strong quality and momentum metrics, but a low value score:

About the opportunity

The potential opportunity for investors in BAE Systems can perhaps be summed up by this chart:

Source: Statista

The UK is BAE’s second-largest customer, after the United States. Since the end of the cold war, defence spending in BAE’s home market has halved as a proportion of GDP.

However, geopolitical events have persuaded the UK government to commit to increase defence spending to 2.5% of GDP by 2027, “with an ambition” to reach 3% during the next parliament.

There’s an expectation that defence spending in other northern European countries will also rise. This trend could lead to a sustained period of expansion for BAE Systems and other companies in this sector.

In such a scenario BAE might be able to justify significant spending on new manufacturing capacity, supporting a lasting increase in its earning power.

Existing guidance and broker forecasts suggest BAE’s earnings could rise by 8%-10% per year over the next couple of years. Those estimates put the stock on a 2027E P/E of 16 – not necessarily expensive if the group is able to deploy new capital at consistent rates of return.

Business & Model

What is the company’s history and what does it do?

BAE’s history can be traced back more than 450 years to the Royal Gunpowder Mills at Waltham Abbey.

Since the start of the 20th century, well-known names that have been absorbed into the group’s operations include De Havilland, Hawkers Siddley, Vosper Thorneycroft, Vickers, Supermarine (the manufacturer of the Spitfire) and Avro.

However, despite this lengthy and storied heritage, today’s BAE Systems plc is a relatively modern corporate entity.

The group was created in 1999 when British Aerospace combined with parts of Marconi Electronic Systems. Prior to that, British Aerospace as a was formed as a nationalised entity in 1977, following which it was privatised in 1981.

Current operations: BAE is divided into five functional segments. Here’s a snapshot based on 2024 sales:

• Electronic Systems: weapons systems and avionics, also including drones, counter-drone and space systems;

• Platforms & Services: land vehicles, tanks, motorized gun platforms and related products such as munitions. Well-known names include Hagglund, Bofors and Bradley;

• Air: missiles, the Typhoon and elements of the Lockheed F-35 fighter

• Maritime: shipbuilding, including nuclear submarines and naval vessels such as the Hunter-class frigate. Also related support activity and munitions;

• Cyber & Intelligence: software and hardware solutions used by governments to gather intelligence and protect against cyber risks.

The majority of BAE’s revenue comes from long-term frameworks and programmes that extend over years, sometimes decades. A relatively small proportion (estimated at c.5% by management) comes from short-cycle products such as ammunition, where visibility is more limited.

Sales are split across a number of core markets where the company tends to have deep and longstanding relationships with its government customers. Former Foreign Secretary Robin Cook joked in his memoirs that "the chairman of BAE appeared to have the key to the garden door to No 10".

How does the business model work?

BAE tends to be a prime contractor on major projects, taking a leading role in sales, customer relationship management, construction and project management. Within this it will subcontract specialist work to many smaller secondary contractors.

Markets & Competition

What is the size and state of the company’s market?

UK defence spending totalled almost £54bn in 23/24, while the 2024 US defence budget was around $850bn.

Against this backdrop BAE’s 2024 revenue of £26bn makes it a leading player, albeit in a large and relatively fragmented marketplace.

As I’ve mentioned already, defence spending by western governments is broadly expected to increase over the coming years. However, ironically, one possible exception to this is the US defence budget, where there’s currently a lack of clarity on the direction of spending under President Trump.

An update is expected in the coming months – one possibility, for example, is that spending on Ukraine aid might be scaled back. US military aid to Ukraine has totalled €64bn since 2022.

How does BAE derive its competitive advantage – and are these advantages durable?

BAE Systems size, geographic reach and broad range of products are likely to provide it with some competitive advantages. Here are my thoughts on these, when viewed through our usual Economic Moat Framework:

Intangible assets: I’ve already touched on BAE’s collection of brands, both legacy and current. But the intangible advantages enjoyed by this business are likely to be much greater.

The group benefits as the owner or manager of complex regulatory approvals, long-term supply agreements, embedded product choices and supply chains and deep relationships with client countries.

In reality, only a handful of companies can theoretically compete with BAE as prime contractors in its main markets.

Switching costs: BAE’s programmes tend to be large, capital-intensive and subject to long-term supply agreements. You can’t simply mix-and-match aircraft or tanks within military units, for example.

The potential cost and disruption caused by an unscheduled switch to an alternative product is often so high as to be completely insurmountable.

Even if individual sub-systems can be switched between subcontractors, BAE’s typical role as a prime contractor means that it's likely to remain in place at least until products become obsolete and due for replacement.

Network effects: in a similar way, BAE may benefit from network effects. Using products and suppliers that are already embedded in the military supply chain can cut costs and should reduce operational complexity – significant benefits, especially during conflicts.

Cost advantages: it’s not clear to me that BAE benefits from any cost advantages when compared to peers in Western Europe and North America. The group’s operating margin of c.10% is in the middle of a range of selected peers, while its return on capital employed is at the lower end of the same peer group.

Greater scale: only a relatively small number of companies have the scale and infrastructure required to act as prime contractors on multiple large land, sea and air programmes.

When political, regulatory and incumbency factors are considered as well, BAE's benefits of scale increase still further. 

Financials & Ownership

What is the record of growth & profitability?

BAE’s growth has accelerated since 2022:

However, the group’s profitability has remained within a fairly narrow range throughout this period and has not (yet) exhibited a clear upwards trend:

As yet, I don’t see any clear evidence the business is benefiting from factors such as operating leverage or improved pricing power. But in fairness, the long-term, programmed, nature of most of BAE’s revenue may mean that these benefits are not yet feeding through.

Balance sheet & cashflow

A characteristic of this business is that customers often make advance payments on new programmes or orders. The impact of this is particularly noticeable during periods when order backlog is increasing. For this reason, recent years have seen very strong free cash generation, significantly ahead of underlying cash conversion.

In this slide, the guidance figures exclude advance payments, while achieved figures include advance payments.

This strong cash flow has allowed the group to invest in organic and acquisitive growth without excessive borrowing. Net financial debt was just under £5bn at the end of 2024 following the £4.4bn acquisition of Ball Aerospace in early 2024. This represents 2.5x net profit and looks a very manageable level of debt to me.

I don't have any concerns about BAE’s cash generation or balance sheet strength.

Is there evidence of historic share dilution?

BAE’s share count has trended slightly lower over the last decade thanks to buybacks.

As far as I can see, there has not been any significant dilution since the group’s formation in 1999.

What is the ownership of the company? Does management have stakes?

If BAE Systems’ management are to be seen as an example, shareholders might want to consider locking in some gains. Management have been consistent sellers since 2023, seemingly selling the vast majority of their share awards and stock options as they’ve vested.

Here are a few examples of stock sales for senior executives and directors since the start of 2023, based on Stockopedia data:

• CEO Charles Woodburn: £24.6m

• Tom Arseneault, President & CEO of BAE Systems, Inc. (US business): £24.8m

• Simon Barnes, Group MD Air: £2.7m

While Woodburn, Arseneault and newish CFO Brad Greve do continue to have significant shareholdings, as required by their contracts, the trend seems fairly clear. Senior executives view shares as additional remuneration and don’t want to have too much skin in the game.

Ownership of the business is largely as might be expected for a FTSE 100 group, split across large institutions.

Valuation

How does the relative valuation compare versus industry peers?

Here’s a selection of BAE’s European and US peers, listed in order of their rolling 1-year P/E ratios. All but two are styled as High Flyers and boast high MomentumRanks and low ValueRanks.

In this company, BAE’s valuation is relatively modest:

What is the stock’s intrinsic valuation?

Relative valuations do not necessarily tell us what a fair value might be. In a sector that’s overheating, a relatively cheap share can still be too expensive. Is this the case with BAE Systems?

City brokers appear to view the shares as trading close to fair value. The consensus price target at the time of writing is 1,629p, roughly 7% above the current share price:

However, it’s worth noting that such price targets often appear to be trend followers, rather than genuine objective valuations.

18 months ago (Oct 23), when the narrative on increased defence spending was already developing, brokers had a price target of 1,147p on BAE Systems. The price target appears to have followed the share price.

One alternative valuation approach for a mature, dividend-paying stock is to value the shares using a dividend discount model. This can be appropriate for shares like BAE that have historically been held long-term, for the income they provide.

BAE has not cut its payout for over 30 years and has a proud record of dividends. Dividend growth since 2019 has averaged 7% per year, due to bumper increases since 2022:

I used a dividend discount model to estimate a fair value of BAE shares. For the period 2025-27, I used current consensus dividend forecasts. After that, I gradually scaled back dividend growth to a long-term rate of 5%.

This gave me a fair value estimate of 1,290p, around 14% below the current share price of c.1,500p.

Of course, models can be used to generate almost any outcome we want. But I think it’s worth considering the risk that BAE’s current valuation reflects a growth rate that won’t be sustainable for more than a relatively short period.

Trends & Catalysts

What underlying trends are affecting the business?

BAE is exposed to a broad trend to increase defence spending by western governments that was triggered by the war in Ukraine. There’s a broadly-held view that many European governments have underinvested in defence in recent decades and may now need to address this.

BAE’s order backlog reached a record level of £78bn last year and the company says that when pipeline and incumbent positions are included (i.e. where management believe BAE is the expected/dominant supplier), this total rises to around £260bn. That’s equivalent to nine years’ sales.

The company is also expanding into growth markets such as cybersecurity and digital intelligence, although growth and profitability in these segments was below the group average in 2024.

Are there any catalysts that could drive a re-rating in the medium term?

BAE is investing in growth through incremental capital expenditure and acquisitions. These have – to some extent – resulted in an increase in the company’s earnings power.

However, analysts’ questions on the 2024 results webinar suggested to me that the company is not yet seen as having made a commitment to deliver a step change in the group’s manufacturing capacity.

When asked about this, CEO Charles Woodburn said BAE would need “a clear demand signal” from client governments. My impression was that he would want near-guaranteed demand for a number of years into the future to press the button on a major increase in production capacity.

If such an expansion went ahead and BAE proved able to generate consistent or improved returns on capital at greater scale, then I think this could be a catalyst for a significant re-rating.

Perhaps more immediately, I think some further re-rating might be possible if there’s evidence of improved profitability as a result of current high levels of capacity utilisation.

Risks

BAE has a long track record of performing acceptably well, with sufficient diversity to smooth out the inevitable lumpiness in some of its long-cycle programmes. I don’t see any reason for this to change.

For me, there are three main risks at the moment that could threaten the outlook for earnings growth and call into question the current valuation.

US demand: there’s a risk that US defence spending could moderate or even slow over the coming years. In the 2024 results call, BAE management said they still anticipated “a slight amount of growth” in the US defence budget but were waiting for an update on forward budgets to get a clearer idea of the outlook.

Even if investment in US armed forces continues to grow, I think there’s a risk that overall spending could be affected by any reduction in aid for Ukraine. As mentioned already, US military aid to Ukraine has totalled €64bn since 2022. BAE has benefited from some of this spending.

I can also see a secondary risk in the US, which is that non-US companies might experience less favourable trading terms. I’ve no idea how likely this is, or if the recently announced tariffs are likely to impact BAE.

However, I did note a recent comment from FTSE 250 defence group QinetiQ, which issued a profit warning in March. At the time, management noted “tough near-term trading conditions” in its short-cycle work in the US, saying it was suffering delays in securing new orders:

In addition, recent geopolitical uncertainty has impacted our usual fourth quarter weighting to higher margin product sales from the US.

BAE management were asked several times on the 2024 results call about trading conditions in the US. They took an uber-diplomatic tone, saying very little except that nothing had really changed yet, but it was still very early days.

In my view, the importance of the US market to BAE can’t be underestimated. North American sales generated 48% of revenue last year and the group’s US division employs half of BAE’s total headcount.

Management argues that the group’s diversified geographic exposure provides resilience against any regional weakness. However, I fear that any slowdown in US demand could be hard to mitigate quickly elsewhere, given the long-cycle nature of much of BAE’s work.

Growth investment: in my view, another key risk is that BAE could commit to major expansionary capex that ends up delivering lower returns than expected – or taking longer to deliver than expected.

This might happen for reasons to do with supply, demand or execution, but it’s a risk that always exists when capital-intensive businesses target a step change in capacity.

Valuation: the recent market sell off has provided a painful reminder that valuations are a reflection of market sentiment as well as fundamental performance.

Changes to the geopolitical environment (or other factors) could see defence stocks such as BAE re-rated to a more modest valuation, more in keeping with their long-term trends.

Recent trading & news

19 Feb 25 - 2024 results: BAE reported sales up 14% to £28.3bn last year, while underlying earnings rose by 10% to 68.5p.

Although order intake fell by 10.6% to £33.7bn, the group’s order backlog rose by 11.5% to £77.8bn. Presumably at least some of this disparity reflects extended lead times for some of BAE’s products, due to high capacity utilisation.

In my review of the results in the Daily Report, I concluded that 2025 forward guidance was in line with expectations and took a neutral view on the stock.

While I recognised the group’s strong trading and (mostly) supportive external environment, I also noted the valuation was significantly above recent norms.

Sentiment & Outlook

What do brokers currently think and are they upgrading estimates?

Consensus estimates have remained broadly unchanged since February’s results, supporting my view that the company’s guidance for the year ahead was in line with expectations.

Broker sentiment has also remained largely unchanged:

What would the person selling to us be thinking and who are they?

I’d imagine sellers in the current market might have one of two reasons for selling (or perhaps both):

• Relative valuation: regardless of the outlook, BAE shares have delivered handsome capital gains but no longer offer a very attractive dividend yield. Taking profits and reinvesting in a higher-yielding stock could provide dividend investors with a significant increase in cash income.

• Growing risk of disappointment: I’ve already highlighted some of the risks to BAE’s growth trajectory, including a slowdown in US spending. A seller might have concluded that the risk of disappointment is starting to outweigh the potential for further upgrades.

Conclusions

As with many High Flyers, BAE’s continued progress is dependent on a mixture of market confidence and continued underlying growth. One without the other might not be enough – but if both are present, the shares could easily continue to new highs.

However, my general experience is that when outperformance becomes a consensus view, disappointment sometimes lurks on the horizon.

In this case, the big risk seems to be the outlook for UK defence firms in the US. I have no idea how to predict how – or if – conditions might change.

Another factor that could influence medium-term progress is any change in the status of the Ukraine-Russia war.

On balance, my view is that BAE Systems isn’t outrageously expensive and is performing well. The business could continue to benefit from supportive external conditions for the foreseeable future. The shares could still deliver further gains.

However, I think it’s also fair to say there are some potential risks in the background at the moment. I’d strongly suggest investors DYOR and form their own view on the situation before considering whether to buy – or sell – this stock.