James Moore: BAE Systems is worth looking at and can improve

Investment View: BAE said it doesn't need to change its strategy. So why the need for the merger in the first place?
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BAE Systems

Our view Speculative Buy

Price 328.5p (-7.6p)

What, has he gone mad? I'm cancelling my subscription. I have to admit that I can see why this might be the reaction to the word "buy" in connection with "BAE Systems". After all, its bosses now rightly have egg all over their faces after their failed attempt at a dog's dinner of a merger with the Franco-German aerospace giant EADS went pop.

But let me explain. I use the phrase "speculative" in connection with a buy when I reckon there is a high level of risk attached to a company and if I see a situation where investors could reap some impressive rewards, but only if a number of things come off. It indicates that this company is a potentially hazardous play and you could easily lose out, but with enough potential upside to make it worth it if you're able to take a loss on the chin.

So hear me out.

First things first. If ethical investing is your thing, and this column is unique in taking that into account, you should avoid BAE. It is a defence contractor with a somewhat shabby history and no place in the FTSE4Good Index, which imposes some ethical standards. So the buy recommendation actually comes with two qualifications.

However, if you're willing to accept that, here's where BAE could be worth investing in. During the merger Neil Woodford, Invesco's top fund manager, put his head over the parapet and took a shot at the company. He said he saw no commercial logic to the transaction and BAE had generally been too interested in the pursuit of deals over the effective running of the company. I've had some hard words for Mr Woodford in the past, but in this case he was bang on.

I can also understand why he has built up a holding that amounts to well over 10 per cent of the shares. BAE is actually very cheap. It trades on just 8 times this year's forecast earnings, while yielding a chunky 6 per cent. That yield is more than two times covered by earnings, so is not at any risk just yet.

What is at risk is whether those earnings can be sustained and improved upon in the future in an era of declining defence budgets. The picture will only become clear in the United States after the election. But what is already known is that spending will have to reduce. And it might reduce more under a President Romney than a second-term President Obama. Republicans love the armed services, right? So they aren't likely to take as much flak for ramming cuts through.

In yesterday's trading update the company said its performance was in line with City forecasts, although an awful lot will depend on negotiations in Saudi Arabia over a Typhoon jet contract together with a procurement deal. Money from the Saudis is needed to help fund a share buyback, which lots of investors say they want.

Controversially, BAE yesterday said it doesn't need to change its strategy. So why the need for the merger in the first place, then? In my view, for the speculative buy to come off, we need to see change at the top. A new chief executive to replace Ian King, with a vision for how to react to the current difficult trading environment in a way that will improve prospects for shareholders. A new chairman might also be useful.

That might help to lift the company's pedestrian valuation.

Don't expect a takeover coming from across the Atlantic. The US would like to maintain its choice of five defence contractors, even if BAE's European shenanigans have led to it losing brownie points stateside.

Over to Invesco, then, and perhaps other shareholders who have privately criticised the merger. They need to agitate, and if necessary use their votes at an AGM to show they mean business. City institutions, despite the ill-named "shareholder spring", are still chary of utilising the powers they have to effect meaningful change at companies they steward.

So that's why BAE, whose shares are undervalued, remains a speculative buy. I'm not confident enough in the current top team to go further, even though the hold recommendation I made in mid-June with the shares at just over 290p has proved a good one.