Today, I want to take a fresh look at BAE and consider a more specialist alternative, Chemring Group (LSE: CHG). This £440m firm specialises in missile countermeasures and sensor-based protection systems.

A solid turnaround?

Chemring has been through a difficult few years. The group reported annual losses from 2013 until 2015 and raised £81m of fresh cash in a rights issue in 2016. Last year, the firm’s Salisbury factory was forced to close after a tragic incident that cost the life of one employee.

However, debt levels are now under control and the firm’s profitability has started to improve. Final results published on Thursday suggest continued progress. Although sales from continuing operations fell 3% to £297m last year, underlying pre-tax profit rose by 25% to £25m. As a result, the group declared a dividend of 3.3p, 10% higher than in 2017.

Reassuringly, Chemring’s net debt was largely unchanged last year. My analysis of the firm’s cash flow suggests that its operations are now generating enough cash to support the dividend and fund some investment in growth.

Buy, sell or hold?

The outlook for 2019 also seems encouraging. That Salisbury factory is expected to gradually reopen, boosting earnings, which City forecasts suggest will rise by 66% to 11.5p per share.

However, sales are expected to fall again this year. This suggests that rising profits represent recovery, rather than growth. On that basis, the stock’s forecast P/E of 13.7, and dividend yield of 2.4%, don’t seem that cheap to me. I won’t be buying.

BAE has done better

While Chemring has been struggling in recent years, BAE Systems has been quietly plodding ahead. The group’s critics sometimes suggest that it’s unlikely to deliver much growth, but the facts suggest otherwise.

The BAE share price has risen by 15% over the last five years. That puts it significantly ahead of Chemring (-30%) and the FTSE 100 index itself (+4%).

I’ve written before about the attractions of this diverse group. BAE’s portfolio includes ship-building, military jet aircraft, vehicles, weaponry, electronics and cyber warfare. Although revenues in some areas can be lumpy and vary from year to year, over longer periods this group is proven to be a profitable and cash generative business.

Strong cash generation is reflected in BAE’s dividend history. The shareholder payout hasn’t been cut for 20 years and has risen by 51% over the last 10 years.

A safe Brexit buy?

BAE’s customers are mostly located in the UK, USA and Middle East. So Brexit seems unlikely to have a direct effect on these relationships. There could be a risk to joint ventures with major European companies but, in my view, this is the kind of problem that tends to get sorted out in the background.

I see this FTSE 100 giant as a very solid buy for income and long-term growth. Trading on 11 times 2018 forecast earnings, and with a 4.4% dividend yield, the shares look decent value to me. I’d buy.

The post Thinking of buying the BAE share price? Read this first appeared first on The Twelfth Magpie.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

However, I believe this weakness is temporary and the shares are set for a near-term recovery as the group reinforces its position in the global defence market. 

Market performance 

BAE’s performance over the past year is disappointing, but the firm’s long-term record of value creation is more impressive. Indeed over the past three years, the stock has returned 10.8% per annum, including dividends, outperforming the FTSE 100 by 3% a year. It’s also registered a similar performance over the past five years. 

The recent underperformance has taken shares in BAE back to where they were at the end of 2017, suggesting the market is ignoring the City’s 2018 growth projections. Analysts have pencilled in earnings per share (EPS) gains of 18% for 2018, followed by an expansion of 9.2% for 2019. These figures suggest the stock is trading at an undemanding forward P/E of 12.7, falling to 11.6 for 2019.

That said, the City’s numbers clash with BAE’s own growth estimates. Back at the beginning of August, management told investors to expect flat earnings this year, after winning a $26bn contract to build warships for Australia.

Last year, the company reported normalised EPS of 36.4p. Based on this figure, the stock is trading at a forward P/E of 15.1. 

Best in the sector

A P/E of 15.1 is not too expensive for an international business with a steady order book, in my view. On top of the attractive valuation, the stock also supports a market-beating dividend yield of 4.2% on a forward basis. 

What’s more, BAE’s valuation is below the defence sector average. Peer Chemring (LSE: CHG) trades at a dearer 16.6 times forward earnings, and has a more mixed-growth outlook. 

After a troubled few years, beset by contract delays and restructuring efforts, analysts had expected the business to return to growth in 2018. Unfortunately, a fatal explosion at its Salisbury factory in August wrote off this expectation. Now, due to lost production and clean-up costs, EPS are projected to fall nearly 40% year-on-year. However, EPS are expected to rebound in 2019 — barring any unforeseen developments. The City is forecasting EPS of 11.7p for 2019, giving a 2019 P/E of 16.5. 

If I had to choose between these two sector peers, I would buy BAE for my portfolio over Chemring. Not only is Chemring more expensive, but the company’s business is unpredictable. Sales at the group have actually fallen by half over the past five years. 

BAE offers a much more stable growth platform with its multi-billion dollar international projects. Further, the shares are deeply undervalued compared to the rest of the global defence industry. Shares in US peer General Dynamics, for example, change hands for 18 times forward earnings. 

On this basis, I rate BAE shares a ‘buy’ as I think they’re due a near-term recovery. 

The post Here’s why I believe the BAE Systems share price could be set for a rebound appeared first on The Twelfth Magpie.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

As it turns out, this forecast was accurate. Since the beginning of 2018, as market sentiment towards the group has improved, shares in Chemring have added 31% excluding dividends, outpacing the FTSE 250 by 30%.

However, I believe the shares will struggle to replicate this performance during the second half of the year. 

Unforeseen disaster

After rising by more than a third during the first half of 2018, shares in Chemring were trading at a premium earnings multiple at the end of last week. Even though the City was expecting a 12% decline in EPS for the full year, shares in Chemring were still trading at a forward P/E of 18. 

Unfortunately, on Friday evening, an incident occurred in a flare manufacturing building at the Chemring Countermeasures facility, near Salisbury, which resulted in the death of one employee and hospitalised another. Following this event, the facility is now out of action and management is, at this stage, unable to forecast how it will impact results. Previously, it was expected that Chemring Countermeasures would contribute £15m to group 2018 underlying operating profit. According to management, operating profit is “now likely to be approximately £10m-£20m lower than previous expectations.” City analysts had been expecting a net profit of £37m for the year ending October 2018. 

This tragic accident is another setback for a company that has struggled to remain profitable for the last six years. Since 2012, Chemring has only generated £47m of operating profit, on total revenues of £3bn, giving an average operating margin of just 2%. Based on these figures, and the group’s relatively high valuation, I’d avoid the stock. 

One company that has a better record of producing returns for investors is FTSE 100 leader Croda (LSE: CRDA). 

A price worth paying 

Croda has gone from strength to strength over the past five years. The speciality chemicals group has seen demand for products surge as the world grows. It manufactures everything from cosmetic products to industrial lubricants, products for the healthcare industry and agriculture business. Over the past five years, as revenues have increased 30%, net profit has surged 57%. Since mid-2013, excluding dividends, the stock has doubled. 

I expect this trend to continue. Even though shares in Croda trade at a hefty 26 times forward earnings, I believe this is a multiple worth paying. Croda is what I would call a wide moat business. The production of chemicals is a highly specialised business with high barriers to entry. It’s not easy to just set up and start producing fertilisers for example. There are whole books of rules and regulations to follow. Croda also has established relationships with customers, who know and trust the group. 

With this being the case, I believe the firm can continue to achieve market-beating growth, and it’s worth paying a high multiple to get your hands on the shares. 

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Rupert Hargreaves does not own any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Some headwinds

In fairness, one reason for this decline is that earnings forecasts for the group have been revised downwards as energy market conditions have changed.

Looking further ahead, there are also concerns about how well the UK’s power grid will cope with future demand from renewables, electric car charging and the potential need for energy storage. National Grid may need to invest heavily to modernise its infrastructure.

A final risk is that a future government might take a more populist line towards the privatised utilities, using price caps and other measures to restrict their profits. However, I suspect these risks will materialise more slowly and gradually than National Grid’s sliding share price suggests.

A contrarian buy?

Adjusted earnings are expected to rise by around 3% to 58.6p per share this year, covering the forecast dividend of 46.2p per share 1.3 times. These projected figures give the stock a forecast P/E of 14.4 and a prospective yield of 5.5%, which seems attractive to me.

That’s especially the case given National Grid’s policy of increasing its dividend in line with inflation. While this results in fairly small increases each year, it does work well for investors wanting a stable income.

And while a dividend cut isn’t impossible, the group’s earnings are expected to improve by 5% in 2018/19. This should widen the level of dividend cover slightly and reduce the chances of a cut.

What about growth?

If you’re looking for a dividend stock with genuine growth potential, one company I’d consider instead is Chemring Group (LSE: CHG). This defence group is still in turnaround mode after a troubled few years.

But today’s full-year results suggest to me that the company’s problems are under control. I believe Chemring could now be positioned to deliver steady growth over the next few years.

During the year to 31 October, the group’s revenue rose by 15% to £547m, while underlying operating profit rose by 14% to £55.4m. Net debt fell by 9% to £80m, while the dividend climbed 131% from 1.3p to 3p per share.

These figures indicate an underlying operating profit margin of 10.1%, which is fairly attractive. Although the group’s free cash flow generation was dented by a number of one-off costs related to its restructuring, I expect these to reduce this year, freeing up more cash for debt reduction and dividend growth.

A potential catalyst

Chemring is the second defence company I’ve looked at this month which has commented that US defence spending seems likely to rise. The US is a key market for it and stronger sales here could help to accelerate growth.

I believe that now could be the right time to buy Chemring as a long-term hold. The shares trade on an undemanding forecast P/E of 14 for the year ahead, and look cheap to me in historic terms. Although the forecast dividend yield is modest at 1.7%, I’d expect this to increase steadily over the next couple of years. Buying now could lock in an attractive future income.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Over the past five years, its shares have fallen 37% and the company has been forced to ask shareholders for extra cash to remain afloat. But it now looks as if Chemring is starting to move on from these issues. This morning’s release shows that revenues for the six months ending April grew to £249.6m, up from £180m in the same period last year. Statutory losses came in at £6.8m, better than the loss of £16.8m recorded last year. On management’s preferred measure of profitability, underlying profits, income hit £17.2m, up from £3.8m. These figures exclude discontinued operations and exceptional items. 

Even though efforts to restructure the business are responsible for some of the revenue and earnings growth, the company also received a boost from sterling gains and a tax credit. On a constant currency basis, revenue for the first half would have been £225.4m and operating profit would have come in at £14.8m. The company also received a tax credit, on adjustments, of £5.8m. 

Still, despite these accounting impacts that are flattering the figures, management also remains upbeat for the rest of the year. Full-year forecasts remain unchanged, and approximately 85% of expected second-half revenue is in the company’s order book.

Commenting on today’s results, CEO Michael Flowers said: “In the first half of 2017 the group has continued to build on its H2 2016 performance, with solid order intake and revenue delivery from its operations. The consistency of manufacturing operations across all sites continues to improve, delivering more predictable revenue flow and improved margins.”

Making progress

All in all, based on today’s first half results, it looks as if Chemring’s recovery is underway, but the company still has plenty to do before it can convince the market that it is once again a safe investment. 

City analysts are expecting the group to report a pre-tax profit of £40.1m for the fiscal year ending 31 October 2017 with earnings per share of 11.4p, giving a forward P/E ratio of 16.4. This multiple seems relatively expensive considering Chemring’s recent troubles. What’s more, for the following fiscal year analysts are not expecting much in the way of growth. An earnings per share gain of 9% is expected for the financial year ending 31 October 2018.

Nonetheless, if the company can return to its former glory there could be huge gains to be made here. At its peak in 2012, Chemring earned just under 25p per share and if they return to this level and the shares maintain their current mid-teens multiple, Chemring could be worth as much as 410p per share, a gain of 106% from current levels.

The post Is it time to buy this cheap turnaround play? appeared first on The Twelfth Magpie.

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