SIF Folio: Can BAE Systems pass my tests?

Defence giant £BA is the second-biggest riser in the FTSE 100 since the invasion of Ukraine on 24 February. Shares in the £23bn group have risen by around 25% since the invasion, and are now trading close to record highs.

Is this a depressingly cynical move by investors, or just a realistic projection of future defence spending? I’m not sure. But what I do know is that even before February, my impression was that BAE’s performance was improving.

BAE’s operations encompass aircraft and shipbuilding, electronic systems, land-based vehicles and cybersecurity. My observation is that this diversity helps to provide a hedge against the lumpiness that can afflict the income from some of BAE’s larger projects.

The company’s 2021 results demonstrated this. All of its divisions generated sales or profit growth, but at a group level both sales and profits increased.

BAE’s underlying sales (including JVs) rose by 5% to £21.3bn, while underlying earnings were 8% higher at 47.8p per share. The order backlog was stable at £44bn (2020: £45.2bn).

These adjusted figures were supported by improved cash generation and a reduction in net financial debt, which fell from £2.7bn to £2.2bn.

BAE’s famously large pension deficit also shrunk in 2021. On an accounting basis, the shortfall halved from £4.5bn to £2.1bn, thanks to strong asset performance and the impact of higher interest rates.

Guidance for the year ahead is positive, too. Underlying operating profit is expected to rise by 4% to 6%, with sales up 2%-4%. This suggests further margin improvements, following the trend of the last few years.

BAE has also maintained its guidance for free cash flow in excess of £1bn per year, which should cover its dividend. However, the rising share price means this implies a free cash flow yield of just 4.3%. In my view, this doesn’t seem especially cheap for a slow-growing industrial business.

However, BAE currently appears to be the top-ranked stock in my screening results that I don’t already own.

The defence group also scores well with the StockRanks, and boasts Super Stock status.

I think the shares deserve a closer look as a possible SIF buy.

Value: middling

ValueRank: 61

BAE’s ValueRank has fallen from 78 at the start of this year to a more modest 61 as I write. But the shares still look affordable to me on some metrics.

To qualify for my SIF buying screen, stocks must have a minimum earnings yield (EBIT/EV) of 8%. That represents decent value for a growing business, in my view. BAE scores quite well, with an earnings yield of 8.8%.

BAE also looks reasonably valued to me relative to its earnings, sales and free cash flow. The only valuation metrics I think merit a closer look are BAE’s price/book ratios:

According to Stockopedia, BAE’s price/tangible book value is negative (shown as n/a). Although this can be a warning sign of financial weakness, I don’t think it’s a concern here.

BAE has a long and complex history of corporate activity, such as acquisitions and disposals. These have left the balance sheet with £11.7bn of intangible assets, but property, plant and equipment (fixed assets) of just £2.9bn.

On the liability side, the group’s equity value is compressed by its £2.1 bn pension deficit and by around £2.4bn of contract liabilities, in addition to normal trade payables, debt and lease liabilities.

There’s a certain lack of asset backing here. But in my view, this isn’t a primary concern. From an investment perspective, I’m attracted to BAE’s cash generation, intellectual property and its order book. These underpin a dividend that’s not been cut for 30 years.

My view: I’m not worried about BAE’s balance sheet, but I do still have some niggling concerns about the stock’s valuation. I feel the share price is probably up with events, but the shares aren’t expensive enough to put me off buying.

Quality: improving

QualityRank: 90

Since taking charge of BAE in 2017, CEO Charles Woodburn has delivered a steady improvement in profitability. This is one of the main reasons for my favourable view of this business.

These improvements have also been paired with strong cash generation and underlying growth. This improving picture is reflected in BAE’s Piotroski F-Score of 8/9, a measure that’s heavily weighted in the QualityRank.

My view: I’m comfortable with BAE’s quality metrics and improving performance.

Momentum: I’m disagreeing on EPS

MomentumRank: 99

BAE’s MomentumRank of 99 indicates that the stock is showing strong price momentum and delivering improving earnings. That’s certainly true.

Price momentum: The StockReport momentum graphic shows a fairly clean sweep of green dots:

Earnings momentum: The other element of the MomentumRank calculation relates to earnings. Stockopedia’s algorithm looks for evidence of upgraded earnings and broker ratings.

BAE scores fairly well here with a recent increase in FY23 forecasts. However, it looks like the consensus rating has slipped back slightly over the last three months. Forecasts are also lower than one year ago.

SIF screen momentum tests: BAE scores well on Stockopedia’s momentum tests, but I’m not sure that it really passes my screening tests.

The SIF screen uses a number of measures to test for momentum and expected near-term growth:

The calculations for the rolling PEG ratio and EPS growth are based on the difference between trailing earnings per share and the stock’s rolling forecast earnings. This is where I have a problem.

When comparing historic and forecast earnings, it’s important to ensure they’re calculated on the same basis. I’m pretty sure that’s not true here:

The 2021 normalised eps figure of 41.6p is significantly different to the eps figures included in BAE’s 2021 results. The company provided three versions of eps last year, but none of them are lower than 47.8p.

I’d guess that most analysts will have based their 2022 estimates on the calculation used to get the 47.8p figure (circled).

On that basis, forecasts for 2022 earnings of 50.2p per share suggest an increase of 5.0%, not the 20.6% suggested in the StockReport. That’s consistent with BAE’s own guidance for 2022:

Based on 2023 broker forecast eps growth of 7.2%, my sums give rolling 12m forecast earnings growth of 5.6%.

=> The good news is that this still satisfies my screening requirement for forecast earnings growth greater than 5%.

However, recalculating BAE’s PEG ratio using this year’s forecast earnings and last year’s underlying figure gives me a rolling PEG ratio of 2.8.

That’s quite different to the PEG ratio of 1.0 shown in my screening results. It’s also a long way above my screening limit of 1.2.

My view: Earnings estimates put BAE Systems on a rolling forecast P/E of 14, with a dividend yield of 3.6%. I don’t think that’s unreasonable, but unfortunately the stock doesn’t pass all my screening tests for momentum.

My decision

Slightly to my surprise, I’m not going to add BAE Systems to SIF this week.

Data-based systems always have some anomalies, even with excellent data like Stockopedia’s. But in this case, I think the expected rate of earnings growth is being significantly distorted.

As things stand, I don’t think BAE shares pass all of my screening tests, even allowing for some wiggle room.

On balance, I think BAE’s price is up with fair value at current levels. I don’t see it as a compelling buying opportunity right now.

As always, please let me know what you think. Am I missing the bigger picture and being short-sighted about BAE’s growth prospects?