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BAE Systems Stock Upgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Britain's BAE Systems (NASDAQOTH: BAESF) (NASDAQOTH: BAESY) is a behemoth, doing more than $24 billion in annual business and valued in excess of $26 billion -- yet it's largely unknown to U.S. investors, a consequence of its stock being traded over the counter and not on major U.S. stock exchanges like the NYSE or Nasdaq. That could change, however, with BAE winning a big endorsement from investment megabank Morgan Stanley this morning.

Here's what you need to know.

Australian naval flag

Morgan Stanley -- and the Australian Navy -- sail to the defense of BAE Systems stock. Image source: Getty Images.

Upgrading BAE Systems

This morning, Morgan Stanley came out with a buy rating on BAE's London-listed stock. StreetInsider.com (subscription required) reported it as an upgrade on the BAESF American depositary receipt.

U.K. website ProActiveInvestors has additional details on what's up. As they advise, Morgan Stanley has upgraded BAE stock to overweight and assigned the stock -- which trades at 633.60 pence locally (roughly $8.10) -- a new price target of 750 pence, or $9.58. With BAESF shares selling for just $8 currently, this implies about a 20% profit for new buyers of the stock.

Morgan Stanley explains its optimism by saying that the "defence spending backdrop" in general "is supportive" of defense contractors, and "contract wins have improved visibility" for BAE's prospects. "[W]e think earnings growth prospects are now higher than at any point in the last five years," argues Morgan Stanley, yet the stock's "multiple has been slow to reflect this" -- which gives investors a chance to buy BAE Systems stock on the cheap.

BAE at the halfway mark

One imagines that a big part of the reason Morgan Stanley decided to take a look at BAE Systems today was because the company reported its H1 2018 financial results earlier this month -- so let's take a look at those ourselves, why don't we?

According to BAE's "Half-yearly Report 2018," published Aug. 1, BAE booked 8.8 billion pounds (that's about $11.2 billion) in sales, earned operating profits of 792 million pounds (a 9% operating profit margin), good for 485 million pounds in profits after taxes and finance costs ($620 million).

Those aren't great numbers. General Dynamics, for example, which competes with BAE in military warships, earns an operating profit margin of 12.8%, while Lockheed Martin, which competes with BAE in fighter jets, earns 11.4%. However, things may be improving for BAE Systems in the future.

Could things improve in the second half and beyond?

For example, in H1 alone, BAE booked new orders worth 9.7 billion pounds, which was a good 10% more than the company billed as revenue in the half -- a book-to-bill ratio of 1.1. This implies that sales, which declined about 7% in comparison to last year's H1, are set to reaccelerate for BAE going forward. This lends support to Morgan Stanley's optimism about the stock.

One contract of particular interest to investors, I'd argue, is the one BAE was awarded at the end of June -- probably too late to figure in its bookings results for the half -- in which Australia hired BAE to build it a fleet of nine new "Hunter" class frigate warships for $26 billion.

As I explained at the time, the price of this contract represents more than one full year of sales for BAE, and that's on top of all the other sales it would ordinarily be expected to make. Even if it takes 20 years for BAE to fully deliver on the contract, therefore, it promises to grow BAE's revenue by at least 5% annually over its term. (Details have not been set yet, but a shorter term to completion -- say, 10 years -- could single-handedly grow BAE's revenue by 10% annually.)

And yet, analysts who follow the stock still have BAE pegged for only 5% annual growth, according to estimates gathered by S&P Global Market Intelligence. When Morgan Stanley says that investors have been "slow to reflect" BAE's contract wins in its stock price, this may be the reason why. Analysts still aren't giving BAE full credit for the size of the win it booked in June.

What it means to investors

So how much credit does BAE deserve? How much should BAE shares sell for? Morgan Stanley thinks 20% more than what the stock costs today sounds about right -- and I think that's very close to the mark.

Consider: Historically, defense stocks have tended to sell for about one times their annual sales (at least, U.S. defense stocks have). BAE stock today, however, sells for less than 0.9 times annual sales, which suggests it's historically undervalued. Now, boost the company's annual sales by the 5% that Wall Street is projecting, add a further 5% or 10% from the Australian frigate contract, and I could see BAE sales rising past $27 billion annually in relatively short order -- enough to justify a market capitalization more than 20% above where BAE Systems stock sits today.

Morgan Stanley is right to recommend it.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.