BAE Systems plc (BA.) Ordinary 2.5p

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BAE Systems reported first-half sales of £14.6bn, up 11% when ignoring exchange rate impacts. All business units delivered growth, with the biggest uplift coming from Platforms & Services due to increased demand for combat vehicles from the US and Europe.

Underlying operating profits rose 13% to £1.6bn, reflecting the sales uplift and a tight grip on costs.

Free cash flow declined from an inflow of £219mn to an outflow of £368mn, largely due to the unfavourable timing of cash payments and customer receipts. Net debt, including lease liabilities, rose by £0.5bn to £7.3bn over the period.

Full-year guidance has been raised, with expected sales growth now at 8-10% and underlying operating profit growth at 9-11%, both up by 1 percentage point.

The shares fell 2.3% in early trading.

Our view

BAE Systems delivered a robust set of first-half results, with strong demand across all business units. That’s given management the confidence to slightly raise full-year sales and profit guidance.

At its core, BAE Systems manufactures heavy-duty military equipment like fighter jets, aircraft and submarines. With NATO members recently committing to boost defence spending from 2% to 5% of GDP by 2035, BAE looks well-placed to benefit from this long tailwind and capture some of this extra spending.

Despite being a UK-based company, nearly 45% of its sales come from the US, making it the largest single contributing region. On an absolute basis, US military spending trumps any other country in the world, so having large exposure to this market is proving very beneficial.

BAE doesn’t expect to be materially impacted by tariffs as they currently stand. The vast majority of equipment it delivers to its US customers is being produced in-country, with largely domestic supply chains.

Demand for the group’s products and services remains strong, with the order book standing at a mammoth £75.4bn, just shy of record levels. Because these are typically long-cycle orders, with revenues spread over several years, it gives BAE multi-year revenue visibility. That’s an enviable asset to have and helps underpin a prospective dividend yield of 2.1%. Please remember no dividend is ever guaranteed.

But keep in mind that profitability hinges on its ability to estimate future costs. The long-term nature of many contracts means that the related risks and costs can change over time. Currently, potential supply chain issues and production delays have been called out by management as the main trip hazards.

Despite the rise in debt to help fund the Ball acquisition, we’re happy with the balance sheet. There’s plenty of free cash flow pumping around the business to manage these debt payments. However, it does mean we could see the rate of share buybacks slow in the near to medium term. Remember, no shareholder returns are guaranteed.

BAE Systems is one of our preferred names in the defence sector, given its diverse portfolio and geographic footprint. The demand outlook is strong, and we think BAE's in good shape to deliver on its long-term growth strategy.

A lot of this strength now looks priced in, with its valuation sitting well above the long-run average. This increases risk, with any missteps likely to be punished. Operational and supply chain challenges will have to be navigated carefully, and some ups and downs along the way can’t be ruled out.

Environmental, social and governance (ESG) risk

The aerospace and defence sector is high-risk in terms of ESG. Product governance and business ethics are key risk drivers. Carbon emissions from products and services, data privacy and security and labour relations are also contributors to ESG risk.

According to Sustainalytics, BAE System’s management of ESG risk is strong.

It has a product safety policy and chain of accountability and assesses safety throughout product development. It has a board-level committee that oversees business ethics risks and has improved disclosure regarding human rights. However, disclosure regarding quality management standards and external certifications are lacking, and BAE should improve reporting on business ethics incident investigations. Employee development programmes are strong and the group has committed to net zero with interim targets in place.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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