Five shares to watch 2023 – fourth quarter update

BAE Systems sits in a key space in the defence market, helping the group to comfortably outperform the broader market over 2023. November’s trading update repeated its full-year targets, with sales and underlying operating profits expected to grow 5-7% and 6-8% respectively.

Demand for BAE’s products and services has flown in over 2023, adding more than £30bn to the order book at the last count. And with raised tensions in the Middle East, we expect this figure will be higher by year-end.

This backlog of work gives good revenue visibility, but keep in mind that profitability hinges on predicting future costs. Longer-term contracts mean the risks and costs can change over time, so there’s plenty of trip hazards if the group loses focus.

The big story of the year was its $5.55bn acquisition of Ball Aerospace, which looks like a good fit to us. Ball has unique positions in critical space and nuclear deterrence technologies. Clearance is moving along and the deal’s set to complete in the first half of 2024.

Initial expectations were that this would add more than $2bn to BAE’s annual revenues. But if expertise and resources can be used effectively, we see that figure potentially rising by two or three times as much, although there are no guarantees. BAE Systems is still one of our preferred names in the sector heading into the new year.

British American Tobacco's (BATS) 2023 organic revenue growth is now expected to come in at the bottom of the 3-5% range, as US combustible sales stay under pressure. That’s seen pressure on the valuation over 2023. And while these headwinds are likely to continue in the new year there’s still room for hope.

New Categories are expected to have been broadly breakeven last year, two years earlier than originally thought. The group has set a punchy goal for non-combustibles to drive 50% of revenues by 2035. We see regulatory scrutiny as the biggest potential blocker here.

Our case for BATS centred on its strong cash generation. With expected cash conversion of close to 100% we still think the company’s well placed to make the necessary investments to keep pivoting away from cigarettes.

It also leaves room to support an attractive dividend yield, which is now in double digit territory after a steady decline in the company's market value. As ever though, there are no guarantees and yields are not a reliable indicator of future income.

The weakness in the valuation suggests that there's still a job to be done in convincing investors that New Categories can underpin BATS' future. Successful execution of the strategy could well drive a re-rating, but it won't be an easy task.

Bunzl put in a good showing in the final part of the year, ending comfortably ahead of the broader market over 2023. December’s trading update gave a welcome push in the right direction, with management raising profit guidance and a slightly more upbeat 2024 outlook than markets were expecting.

But finding organic growth has been a challenge throughout the year, with revenue expected to fall 1-2%. Bunzl tends to benefit from inflation as it can pass it on to consumers, boosting revenue. So, the fall last year has been a headwind compared to the year before, as has a drop in Covid-19 related sales.

Despite that, the strengths of this business are in its strong and essential product range (think food packaging and safety equipment) and its highly cash-generative model. This lets it self-fund expansion through acquisitions. Bunzl’s a mashup of smaller businesses, so acquisitions are key.

We were also impressed to see margin expansion even with the softer revenue performance. That tends to be a sign of a well-run business with control over its operations.

The key thing to watch is how organic growth plays out from here, continued weakness in this area puts added pressure on acquisitions to do the hard work. Still, for longer-term investors, we’re still supportive of the name.

PayPal’s third quarter revenue came in at $7.4bn, with underlying growth of 9% – ahead of market forecasts. Its fourth quarter revenue growth is expected to land between 7-8%. But full year underlying operating margin expansion guidance was still lowered for the second time last year.

Cost cutting can only go so far to offset the lower margin contribution from the unbranded business, Braintree, where the company is purely a payment processor.

But there is some hope that it won’t keep aggressively discounting like we’ve been seeing. There’s also a plan to revive growth in the higher margin branded business, which leverages the iconic PayPal button. Even though it’s a popular name with consumers, the customer journey has been a little behind the times.

Enter a new improved one-click button that’s being bundled with Braintree. But while Braintree is mainly focusing on bigger merchants, the PayPal branded business is more focused on small and medium-sized businesses.

Launching a processing solution for smaller companies last year has given a chance to reengage PayPal’s target retailer market and shore up growth in branded revenues.

With the valuation well below the long-term average, the market’s not expecting a huge turnaround. We still see structural growth drivers for the digital payments industry, mixed with impressive market share, as an attractive proposition. But PayPal needs to keep modernising its solutions to keep up with the competition.

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Truck and equipment giant Volvo Group has seen its valuation rise around 36% last year. That’s come from a combination of better-than-expected results and strong handling of a tough inflationary landscape. Past performance is not a guide to the future.

The group’s third-quarter sales rose 9% to SEK132.4bn, ignoring the effect of exchange rates. Underlying operating income was SEK19.1bn, up from SEK11.9bn.

The positive development comes as supply chain issues and higher costs from things like labour, production and transformation-related costs were offset by higher prices. This helped underlying operating margins rise more than four percentage points to 14.4%.

The last quarter hasn’t been without challenge though. Free cash has spun to an outflow. This is partly because of normal seasonal patterns of Volvo’s cash flow – the nature of the business model means this is quite lumpy. The group’s confident that efforts to right-size inventory will help things stabilise and we’re cautiously optimistic, but it will need watching.