BAE Systems (LSE: BA) shares got a massive boost on 31 August as Norway made a £10bn deal for five Type 26 Frigates. These anti-submarine ships will be built in shipyards in Glasgow and are intended to prowl the North Atlantic ocean along with Royal Navy counterparts.
While no one wants naval conflicts near our waters any time soon, the best way to secure peace is to be well prepared for the alternative. BAE Systems shares only rose a couple of percent on the day. But the share price has now tripled since Russia first invaded Ukraine.
The real story here however isn’t in a solitary order for a few ships. But it’s for a potentially seismic shift in global military spending. Let me explain.
What’s changed?
The UK wasn’t the only country in the running to fulfil Norway’s order. Among the four in the procurement process, the US had a place too. Why didn’t Norway plump for the world’s undeniable military giant? One claim is that the Nordic country was spooked by recent decisions by American top brass. That’s when it (temporarily) withheld shipments and intelligence sharing with Ukraine.
The question on people’s minds might have been: is Uncle Sam permanently changing its relationship with Europe? Is the post-WW2 status quo a thing of the past? While I won’t be delving into that can of worms, it seems clear that the balance of geopolitical power is shifting. And as European nations ramp up military spending to 3%, 4% or even 5% of GDP in the face of external threats, European defence firms like BAE Systems might play an even larger role in building the equipment the continent needs.
A few risks
That isn’t to say this makes the stock a slam dunk buy. The surge in the BAE Systems share price has inflated the price-to-earnings ratio to 28. That figure is some way above the commonly cited fair value of 15. Even with a full order book, that’s going to be a lot of growth needed to justify such a valuation.
Europe’s largest defence contractor will also be grappling with high energy costs. Energy, of course, is a large cost for most manufacturing firms. The UK has some of the most expensive industrial electricity in the world. Going forward, it won’t be easy for defence firms to stay competitive if the country doesn’t get a handle on these costs over the longer term.
In spite of those risks, I believe this is certainly a stock to consider. The Norway decision could be a sign of things to come, and BAE Systems might be one of the best-placed businesses to benefit from a shift in governmental defence spending. That’s one of the reasons I’m happy to hold the stock.
