The Stock Picker's Guide to BAE Systems

LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.

In this series I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety and valuation. How does BAE Systems  (LSE: BA  ) (NASDAQOTH: BAESY  ) measure up?

1. Prospects
Defense markets are defined by geopolitics. BAE's market is limited to NATO and other Western-friendly powers such as Australia, Saudi Arabia and India. Even within NATO, national interests constrain business in most European nations.

Austerity measure and diminished appetite for Middle Eastern adventures have hit defense markets hard. Sequestration in the U.S. hasn't affected defense procurement as much as feared -- cutbacks have focused on operational budgets.

BAE is the world's third-largest defense contractor, with its leading position in the U.K. market (20% of sales) enshrined in public policy, and a strong position in the U.S. (40% of sales). It's diversifying into civilian applications (especially cyber-security) and non-NATO markets, but the scope is limited.

2. Performance
These factors have led to a decline in sales the last two years, taking them back to 2008's levels. EBITDA has followed suit.

Analysts expect a return to sales and profit growth for the next two years, in part because BAE has been good at cutting costs to match order volumes.

The company has maintained a return on equity between 11% and 16% since 2008.

3. Management
Chairman Dick Olver barely survived BAE's failed bid to merge with EADS, and is expected to step down by the end of this year.

Ian King has been CEO since 2008 and, like Olver, was respected before the EADS episode. However, his scope to pull off strategic initiatives is diminished by that debacle.

4. Safety
Long-term contracts, such as BAE's 17% share of the U.S. F-35 fighter program, and an order book of over a year's sales, provide visibility to BAE's revenues.

Long-term contracts can have an arbitrary effect on annual accounts. A movement of two billion in creditors was largely responsible for the company's free cash flow jumping from £0.4 billion to £2.4 billion between 2011 and 2012.

Overall the company's cash flow comfortably covers its fixed costs and it plans to spend £1 billion on share buy-backs, subject to successfully renegotiating its Saudi fighter contract.

Gross gearing of 80% is manageable. A pension deficit of £4.6 billion (against net assets of £3.8bn) deriving from a £25 billion gross pension liability adds financial risk. Intangibles of £11 billion dwarf net assets.

5. Valuation
BAE's prospective price-to-earnings ratio of 9 and yield of 5.3% reflect the risks to its future revenues and weak balance sheet. But the prospect of substantial buybacks has pushed the shares, still ex-div, to their highest levels for four years.

Conclusion
BAE isn't the highest quality blue chip, but the fat yield helps investors overlook its deficiencies. It has a secure position in a safe business.

BAE's biggest shareholder is Invesco Perpetual's high income fund, run by Neil Woodford. Woodford has an unrivalled record for stock-picking. His fund is "the best performing of any fund investing in the U.K. since it launched" according to Hargreaves Lansdown. It has grown at 12.6% a year since 1988.

You can learn more about how Woodford selects stocks in this report from the Motley Fool: "8 Shares Held By Britain's Super-Investor". You can download it by clicking here -- it's free.

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