War payouts put BAE shares on the up as arms firm withstands Saudi setback

Outlook for the British defence company's shares is strong, amid a rally triggered by the conflict in Ukraine

A Eurofighter Typhoon fighter aircraft produced by BAE Systems. Much of BAE Systems earnings come from fighter aircraft programmes. EPA

When Guillaume Faury, chief executive of Airbus, publicly voiced his concerns over Germany's “damaging” foot-dragging on a new batch of sales of the Eurofighter Typhoon fighter jet this week, he was speaking as much for the British defence giant BAE as his own interests.

For decades, the Typhoon has symbolised BAE's strongest Middle East relationship but sales of a batch of 48 aircraft are subject to a German veto and caught up in that country's coalition politics.

Whereas the issue might once have dogged BAE's stock market standing, the rising tide of global defence sales mean its relentless share price has been barely trimmed.

“BAE sales are diversified across several arenas including electronic systems, maritime related equipment, cyber and intelligence and aircraft sales,” Keith Bowman, investment analyst at Interactive Investor told The National.

“During 2022, aircraft-related profit proved its biggest earner, followed closely by electronic systems, with maritime equipment a clear third.

“As such, sales to Saudi matter, although must be taken within the context of the diverse bigger picture.”

Overall, economists tend to agree that wars are not good for economies. They mess with demand, redirect resources that would otherwise be gainfully employed and destroy economic infrastructure.

Modern conflicts mess with economic demand and destroy prewar business, apart from inflicting more wide-reaching effects, such as on the price of oil.

One industrial sector that does well in times of heightened geopolitical tension is defence, a fact that has been reflected in the recent share price performance of the UK's largest defence company, BAE Systems.

Geopolitical tension and conflicts such as the Russian invasion of Ukraine, the Israel-Gaza conflict and any potential China-Taiwan tension have fed a rising tide for the sector.

Shares in BAE Systems have soared in value by 151 per cent in the past three years and have gained about 10 per cent in the last month alone.

With a market capitalisation of about £33 billion, BAE Systems coffers are, for the most part, filled by the earnings from fighter jet programmes, which include the Eurofighter Typhoon and F-35 Lightning.

Last year, BAE Systems' largest markets were the US, the UK and Saudi Arabia.

'Indirect beneficiary'

The UK government defence budget has been increasing for some time, especially following the Russian invasion of Ukraine, when there were renewed calls for an increase to defence spending.

In 2021-2022, the UK spent £45.9 billion on defence. In his budget back in the Spring of this year, UK Chancellor Jeremy Hunt announced an additional £5 billion to defence spending over the next two years, and a further £2 billion a year in subsequent years up to 2028.

This increases defence spending by a total of £11 billion over this five-year period.

“BAE is directly impacted by the Ukraine war, because various countries are providing Ukraine with arms and BAE is a key government contractor,” Jamie Murray at Shore Capital told The National.

“With respect to Israel, I would view BAE as an indirect beneficiary. It doesn’t have a material exposure to Israel’s defence supply chain, but the conflict is ratcheting up geopolitical tensions, which in turn typically leads to higher defence spending which does benefit BAE."

But even though BAE Systems may have no "material exposure to Israel’s defence supply chain", hundreds of trade union activists blockaded the company's factory in Kent on Friday, under the banner "Workers for a Free Palestine", accusing BAE of supplying parts for the aircraft being used in the bombardment of Gaza.

BAE Systems shares are up 26 per cent so far this year and their earnings per share (EPS) have grown by 19 per cent, which compares favourably to a FTSE 100 index loss of about 2 per cent so far this year.

“BAE Systems’ share price stands at an all-time high for a variety of reasons, but the latest strong run seems to have its origins in the Russian invasion of Ukraine in early 2022,” Russ Mould, investment director at AJ Bell, told The National.

“A new conflict in the Middle East is also reminding investors of the potential value of defence stocks after a long period when environmental, social and governance (ESG) concerns and screens saw many portfolio builders intentionally exclude them from consideration.

“Those investors with long memories may also hark back to the 1970s, when defence stocks were one of the very few groupings to thrive during a time of conflict in the Middle East, oil price shocks, sticky inflation and soaring interest rates.

“That performance owed much to the [regrettably] consistent nature of demand for their products, which also conferred a degree of pricing power, a useful facet when input costs were rising,” he added.

For Mr Bowman, BAE’s performance so far this year has been “rewarding”.

“A 26 per cent gain in the price during 2023 compares to 0.5 per cent loss for the FTSE 100 and a 1.15 per cent retreat for the FTSE-All Share index,” he told The National.

“That said, other defence exposed companies Rolls-Royce and Babcock have generated gains of 137 per cent and 43 per cent year-to-date.”

There is no doubt that geopolitical tension and conflict have provided the support for BAE Systems soaring share price in recent years, but what of the future?

At least some of the increase in defence spending by governments, including the UK, will find its way into BAE Systems' sales ledger and then to the profit and loss account. But have those investors who do not currently hold BAE Systems shares missed the boat?

As a mathematical rule, when share prices rise, their dividend yields drop, meaning that those who invest late in a share make less money back as the price rises.

In BAE Systems' half-year results back in August, the company made two announcements that perked up yet more interest in the shares: An 11 per cent rise in the share dividend and an order book backlog worth a record £66.2 billion.

Given those figures, some analysts argue that even given its impressive share price rise, BAE Systems remains a solid invest for many.

“BAE has a track record of delivering a consistent and progressive dividend, which is highly valued by income investors,” Mr Murray told The National. “If there is an impact on income investors, I would argue it is immaterial.”

The current average price target of BAE shares among its analysts is 1,202.33 pence with a high forecast of 1,285.13-pence and a low forecast of 1,121.00 pence. That would be pretty impressive, given the shares started 2023 around the 860-pence mark and five years ago were hovering around 500-pence.

Saudi Arabia deal

The Saudi relationship remains lucrative for BAE and the Germans have not fully slammed the door on the Typhoon G5 sale. Mr Murray believes there may be some small uplift to the shares, should Germany decide not to use its veto in the final instance.

“Exposure to Saudi Arabia is a key risk factor that investors consider,” he told The National.

“If Germany get rid of their veto, it would mean this risk factor is slightly reduced, which makes the investment case slightly more appealing.

“However, it won’t have any impact on forecasts because analysts currently assume business as usual in Saudi Arabia.”

China and Taiwan

Defence stocks in general are coming back in vogue, as the world starts to feel a less safe place than perhaps it was seven or eight years ago, and governments refocus attention on their armed forces.

“The investment case for defence stocks rests upon consistent demand for their products, and the pricing power this confers, especially once service revenues are taken into account,” said Mr Mould.

“Fat order backlogs can provide good visibility, too, although contractors must then deliver to specification on time and avoid cost overruns.

“Wars and conflicts can be reminders of these potential attractions and the world does feel a less stable place now than it did 10 or 20 years ago, especially as China-Taiwan remains a potential flashpoint in the future, given the technological cold war that is playing out between the West and Beijing right now.”

Experts predict that the current geopolitical tension is not expected to be reduced any time soon, and, if anything, more could be added into the mix within the coming years.

“Even in times of ‘relative’ peace, there are always global tensions and, as such, defence companies benefit as governments work on upgrading existing equipment or start developing the next generation of weapons,” Mr Cole told The National.

“This is certainly the case in Europe, the US and Russia where there is a constant battle to keep ahead of your rivals, and now China is very much joining this race too.

“Globally, most governments spend on defence every year, and so there will always be money to be made in the defence industry.”