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BAE Systems

Clouds set to clear at BAE Systems?

BAE has had a number of big contract wins recently, with over £1 billion of new orders in the past two months. Revenue is expected to grow by 20% this year and earnings per share by 13%.

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… At current levels the group has strong appeal to both value investors and short term traders. Directors have been buying recently and it is likely that their defensive qualities will come into focus over the summer when the markets tend to display their customary weakness.



As can be seen from the above chart of the FTSE 100 it has been another largely flat week, with the index remaining within its six week sideways range.

Earlier in the week the banking sector was boosted by the news that Lloyds and ten other leading US banks would re-pay government bail-out funds, which is viewed by many as a sign of a healthier balance sheet and confidence in their outlook.

Fresh indications of an improvement in global economic conditions and further weakness in the US dollar have boosted commodity prices and related stocks this week. Oil has risen more than 120% from the December low of $32.4, copper is at eight months highs above $5200 a tonne and Aluminium touched its best level since early December.

The lack of movement in recent days has failed to clarify the medium term direction and technical analysis of the above chart highlights the tight range the index has been trading since early May. The relative strength index (RSI) is in a downward trend, which suggests that the underlying momentum behind the recent strength is falling and a move lower could be likely.

The FTSE has had three failed attempts to break the recent highs of 4525 and with the momentum declining it is becoming increasingly unlikely. A move below the lower channel line at 4300 could initiate a further move down towards 4000.

However, the US markets have moved above their comparative short term ranges and posted fresh higher highs, which in turn could drag the FTSE up. The bulls need to see a rally through 4525 to continue the recent uptrend and make an assault on medium term resistance at 4640.

In summary, the recent range between 4300 and 4500 looks set to continue, with a bias to the upside due to the recent strength in the US. Traders could consider trading the extremities of the range or opening a buy FTSE and sell DOW pair, as the recent outperformance in the US is likely to unwind over coming days.

Due to their defensive nature aerospace and defence companies have underperformed the wider market over recent months, with the sector average falling around 6% in the last 30 days.

However, recent reports show that world military spending hit a record high in 2008, boosted by the Iraq war, the return of Russia as a global player and the emergence of China. World arms expenditure totaled $1.464 trillion last year, which was up 4% from previous year.

The US is by far the world’s biggest arms spender, representing almost 42% of total arms expenditure. China and Russia have also tripled their military spending in the past ten years.

BAE Systems (Epic: BA.) is the third largest global defence company, with annual sales in excess of £18.5 billion. The group updated the market on the 6th May, stating that the first quarter of 2009 had been in line with expectations and that it continues to anticipate another year of strong growth.


As can be seen from the above chart of BAE Systems the shares have fallen around 15% in the past month back down to key support levels.

An element of the recent weakness has been due to renewed concerns that governments may cut back on defence spending in light of the extent of public sector expenditure recently.

There is talk that Britain is unlikely to buy all of the 48 remaining Eurofighter Typhoon jets it has signed up for and there is growing pressure from its German, Italian and Spanish partners on the Eurofighter program to stop holding up the aircrafts third production run by making an overdue £1.45 billion payment.

Talks are ongoing and BAE is suffering as the market does not like the uncertainty surrounding the deal. However, pulling out could result in the government having to pay up to £2 billion in compensation and given the political cost of the project, the government may well have to pay up in full, which will benefit BAE.

Furthermore, BAE is set to benefit from the US budget changes, with the US government’s increased focus on irregular warfare, intelligence, security and the potential replacement of legacy aircraft with the F-35.

The recent weakness of the US dollar is another reason for the poor performance of late. BAE generates 58% of its sales in the US and the weaker dollar results in lower revenue in real terms when transferred back into Sterling.

However, its US sector peers have outperformed BAE by around 40% since March and given that it is the fifth largest defence contractor in the US and has a more robust balance sheet than many of its US competitors, it would appear the sluggish performance could be an anomaly.

BAE has had a number of big contract wins recently, with over £1 billion of new orders in the past two months. Revenue is expected to grow by 20% this year and earnings per share by 13%. The group pays a healthy dividend of around 5% and is trading on a forward earnings of 8x, which puts them on an attractive PEG ratio of 0.6.

Technical analysis of the above chart indicates the importance of current levels, with 320p providing support since March of this year. The RSI is in oversold territory, which suggests that the recent weakness could be overdone.

At current levels the group has strong appeal to both value investors and short term traders. Directors have been buying recently and it is likely that their defensive qualities will come into focus over the summer when the markets tend to display their customary weakness.

At the time of writing the share price is 323.25p and my short term opinion is positive. A tight stop loss marginally below key support at 313p makes this a low risk/high reward trade with near term targets seen at 338.5p, 347p and 364p.



This report was written by Mark Allen – Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in BAE Systems. The material in this report has come from Simply Charts and BAE System’s corporate website.  

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