BAE Systems is underrated

BAE Systems has had a stunning run since April. Its share price has rocketed by a quarter to a six-year high, outperforming the FTSE All-Share index by an incredible 20%. Clearly, conflict in Ukraine and the beginning of what will likely be a lengthy conflict in Syria and Iraq is good news for the defence industry.

And BAE's third quarter has been largely trouble-free. It received £7.9 billion of orders in the year to 23 August, a third of which were from outside the UK and US. And the Scottish vote to stay within the UK abolishes the uncertainty (and potential cost) that would have accompanied a nationalist victory - BAE has huge shipbuilding operations both on the River Clyde in Glasgow, and Rosyth in Fife.

There was the usual warning that has become necessary in recent years given the fractious political climate in the US. "Some limited trading disruption is likely in the last quarter of the 2014 calendar year as the government operates under a Continuing Resolution from 1 October 2014 which keeps the federal government running at fiscal year 2014 spending levels," it said.

Be prepared for order volatility during the fourth quarter, although it's unlikely to be as spectacular as in recent years. And as BAE said at its half-year results in July, the bipartisan budget approval in December is providing improved near-term clarity, and both procurement activity and commercial aircraft electronics work is picking up. Restructuring in the US is keeping costs down, too.

There has been another £30 million post-tax charge at the US surface ship support business - £1 million of charges were taken on US commercial shipbuilding programmes in the first half - and the total now stands at £73 million pre-tax.

Still, BAE is sticking with its full-year earnings outlook. Broker Espirito Santo recently trimmed forecasts and now expects adjusted earnings per share (EPS) of 37.9p in 2014, rising to 40.5p next year and 41.8p in 2016. If BAE can proved earnings have, indeed, bottomed, the price-earnings (PE) discount to US rivals should continue to narrow, says the broker (see chart below).

Espirito reckons BAE, which at 469p is currently trading on 12.4 times forward earnings, should trade in line with the sector average of 13.5 times. That would value the shares at 510p.

BAE appears to have turned a corner and the key drag on revenue - the US Land Platforms division - now accounts for just 10% of sales. The company is half-way through a £1 billion buyback programme, too, which continues to underpin the shares. Consider also a prospective dividend yield of 4.5% and BAE still looks good value.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.