BAE shares drift off all time highs ahead of full year results

Rolls-Royce’s flight back to market affections was spoiled by alleged “improper” behaviour this week, but earnings from BAE Systems on Thursday will show if the investment gap between the UK’s biggest two aerospace and defence rivals is closing.

Judging by its performance in its last financial year, Rolls would probably have some catching up to do, but the market is not taking a solid full-year performance from BAE as a given.

Market conservative on BAE growth outlook….

Underscoring low market expectations, BAE’s current one-year forward price/earnings ratio of 13.84 times ranks it at the bottom of a peer group including Chemring Plc., Safran SA, Dassault Aviation and even the world’s biggest defence company, Boeing.

Admittedly, many of BAE’s regional rivals struggle elsewhere in their growth profiles—Rolls-Royce (on 15.65 times) is in the throes of a humbling ‘recalibration’, whilst Chemring’s negative return on assets suggests less-than-optimal capital (and perhaps management) efficiency.

…and cautious amid nearby turbulence

For its more immediate future, BAE warned in February last year earnings would fall by 5%-to-10% in FY 2014 from the £1.9bn reported in 2013, due to defence spending cuts.

BAE also reminded investors of a basis effect from a deal with Saudi Arabia that had inflated its bottom line in the prior year.

But even after impairment charges totalling £112m to be booked in full-year results, BAE maintained guidance for 2014 net income no lower than £1.71bn.

The market hasn’t quite taken BAE at its word.

Perhaps trying to prepare for signs of moderating growth, consensus forecasts compiled by Thomson Reuters within the last month show institutional investors on average expect adjusted net income of between £924m and £866m.

BAE revenues are expected to have fallen about 7% to £16.9bn and to edge 1.5% or so higher to £17.16bn in the next financial year.

Cyclical mechanical

Against the shaky earnings backdrop in its last financial year, BAE’s long-term stock price performance reminds us that it’s essentially a cyclical beast.

It fractionally underperformed the benchmark index over the last decade, but certainly hasn’t been as hamstrung as dozens of its index peers.

With the share price more than doubling from three-year lows in August 2011 to tonight’s close at 520.5p, BAE System Plc. is just pennies away from all-time highs.

The stock will therefore be vulnerable to any potential let-downs in its annual results.

Yields to investors despite downturn

It’s worth reminding ourselves just why shareholders flocked to this firm.

Despite the aerospace and defence sector having come under pressure during recent global economic slowdowns, as government budgets were cut, BAE’s full-year payment between 2009 and 2014 grew at a compounded rate of 6%.

Rolls-Royce’s 5-year CAGR blazed faster at 10%, but that looks likely to slow to at least half now, amid its tumbling earnings.

FTSE 100 companies only averaged 4% during the period.

The most defensive in UK aerospace & defence

Compounded growth of course goes hand in hand with BAE having long been favoured for its reliable shareholder returns.

At 3.9%, BAE’s dividend yield is now unmatched in the UK aerospace and defence sector.

And, despite recent road bumps in earnings, consensus forecasts backed with company statements suggest little likelihood of dividend growth stalling—a 2.9% rise is what the market expects between the final 2014 pay-out and one for next year.

Sound global positioning

So whilst the market is tardy over BAE in the medium-term, consensus dividend views suggest the market is well aware of its fundamental strengths that go with its ‘territory’.

That territory is largely in the US, where it generated about 37% of its revenues, judging by the most recent assessment of its geographic mix.

With US defence spending cuts widely forecast to moderate in 2015 after spend fell more than 30% since 2008, BAE would appear well-positioned to benefit.

October data showed US military spending marching 16% ahead between July and September 2014, the fastest pace since 2009, even if that tells us little about the typical volatility seen in defence contract order books.

In sum, BAE will need to ensure shareholders get the message that a cyclical upturn in earnings is in all probability close.

And, of course, that this revival will be reflected in continued dividend growth.