Posted on the Value Lab 4/22/22
BAE Systems (OTCPK:BAESF) (OTCPK:BAESY), like many other defense companies, has seen price increases with the war in Ukraine, creating momentum for larger defense budgets among European nations. He is it was about time, as most of Europe was also behind on its NATO minimum spending commitments. Defense has generally increased as diplomacy appears to be more of a means of subversion and setting the stage for further military action by China as well, with the Russian invasion proving there is an appetite in the east for some degree of warfare. In many ways, BAE deserves its recent surge, with fine exposures to Australia facing the Chinese sphere of influence, as well as Europe facing Russia, to support the backlog. commands with new commands. However, the Saudi exposure looks riskier than before. In addition, Dassault Aviation (OTCPK: DUAVF) remains unequivocally the better deal compared to BAE, so we’d rather look for something new in the US.
Puts and takes
There are a few things investors might consider regarding BAE’s investment case. Starting with the positives.
- Aukus’ exposure continued to be a source of strength supporting the British defence. Specifically, and more recently, the importance of defense considerations has increased for Australia as China establishes its influence in the solomon islands. Diplomats see this as a major mistake by the West, where they allowed the Chinese to establish a presence in the Pacific theater. Do you remember the Guadal Canal? Many people died there during World War II due to its strategic importance. China now has a security pact with the islands, which should highlight Australian security concerns, hopefully supporting other Australians’ business. Australia is already committed to the F-35 program, for which BAE provides electronics, but explicit Australian exposure could expand over time, as Australia has indeed made defense commitments recently, by referring to the quote given below this listing.
In Australia, BAE Systems is the largest local defense company and is considered and valued by the government as a truly Australian company. The recently announced four-structure plan increases defense capability spending in Australia by 40% over the next 10 years, with a focus on local and indigenous capabilities. (Charles Woodburn, CEO of BAE)
- The Eurofighter resumes with a beautiful German order as Germany finally promises to catch up on its defense commitments, with the political capital now backing a less pacifist approach from Germany. It’s quite a short time, especially compared to recent orders signed by Dassault, but the situation with Ukraine will support greater European spending. The more Typhoons they sell, the more platform they have to generate ongoing recurring revenue. There are many potential customers in Eastern Europe for manufacturers of jet aircraft in the Eurofighter price range.
- Honestly, the Tempest looks more promising than the Franco-German-Spanish coalition for a 6th generation fighter, which is running into major problems, with Dassault issuing an ultimatum to its partners. While not commercially relevant at the moment, it could come in later to meet European defense needs, although Brexit has supposedly taken Britain out of Europe’s good graces.
There are also a few negatives that we want to point out.
- The F-35 exposure is decent, but not our favorite. We are not impressed with the direction the program is taking, and while there are orders from allied nations heavily influenced to the United States, the United States itself is looking to deviate from one’s own program. BAE remains highly dependent on these revenues.
- The reversal of newbuild fortunes in commercial aviation after the third quarter of last year hit BAE’s commercial segments, which contribute better to margin than defense segments. This translated into weaker earnings growth on top of already rather anemic sales growth.
- The Saudi exposure, which represents 13% of revenues, continues to make us think. First, it is a major ESG concern. But much more importantly, Saudi Arabia is not too happy with Western nations, and is not very cooperative now that it holds all the oil cards. They are particularly upset that Biden is courting countries like Iran to potentially re-enter the oil market. Defense depends very much on the goodwill of these nations towards the West. There are fewer now, and there are other competitors in the defense landscape. Although BAE is still supplying Typhoons to Saudi Arabia and that will not change, the concern would be for future business.
BAE is a nice company, but it’s not a top notch exhibit. For those you need to go to the United States, which trades at a premium in defense for good reason indeed, innovation and the importance of American influence go hand in hand. The problem is that at 8.8x it is also trading much more expensive than Dassault, which is of a similar level, if not better given Dassault’s performance in securing Rafale contracts over the past 12 months. Dassault continues to trade only slightly less in market capitalization than its own cash balance and holdings of other high-profile French stocks. It remains very inexpensive and still offers significant advantages, including on private jets. BAE, on the other hand, has riskier business exposure and heavy reliance on the F-35 program as a contractor. While defense remains attractive in current markets, we prefer to opt for quality in the US or stick with Dassault, which is much cheaper in the second tier of defense stocks. Overall, BAE is not a priority at the moment.