Investors should look at BAe Systems

Nov 2 2009 Share Watch with Andrew Miller, The Journal

BAe Systems – We expect good growth. There is scope for upside surprises and it has a strong balance sheet to fund acquisitions. We believe this is attractive against recession- impacted earnings and cash-flow pressures elsewhere.

BAE shares have, however, underperformed recent rallies. These rallies look to be based on optimism about an economic recovery favouring cyclical stocks over defensives. Such sector rotation will hit the rating of defensive earnings as risk appetite rises and as defensives are sold to buy recovery situations. So the choice is between the growth and relative confidence in defence names, but where sentiment could erode ratings, and an uncertain outlook for cyclical stocks, but potentially improving sentiment.

We retain a buy on BAE due to an attractive valuation and as we believe it has good prospects. We feel there is a case for an overweight position for longer-term holders, but investors should consider including more economically sensitive positions in portfolios to protect against sector rotation. Fair value is based on a premium to the sector average.

BP – BP remains attractive for its yield despite a mediocre medium-term outlook for exploration and production, in our view. Volume growth guidance is 1-2% to 2013, despite good reserve replacement performance, but the latest results have shown that the aggressive cost-cutting measures are starting to take a toll. The message on dividend preservation remains strong. Management previously stated it was ready to go above its gearing target for a period if necessary, in order to maintain shareholders’ returns, showing its confidence in a recovery in the oil price in the longer run and a significant drop in industry costs. Our fair value of 620p is based on a 10% premium to the average multiple for oil majors, to reflect the higher and safer dividend.

Whitbread – We are upgrading our recommendation on Whitbread to outperform following strong first-half results. We see significant upside potential to earnings on a two to three-year view. This is associated with corporate activity, which could accelerate the expansion programme. However, we now find the valuation attractive even in the absence of such activity. We have looked at the likely effect of the 10,000 new rooms in the pipeline and if all opened by 2012, our model would understate pre-tax profit by at least 7%. We have increased our price target to 1449p.

We now believe that Whitbread is one of the most attractive stocks in the European leisure sector. Due to the lower level of operational gearing at Whitbread, we would expect the stock to trade at a discount to the peer group on one-year forward earnings, but if we look out three years the multiples should converge.

Andrew Miller is regional office head of Barclays Wealth in Newcastle