BAE Systems PLC (LSE:BA.) remains Morgan Stanley (NYSE:MS)’s top pick in the European defence sector, with its optimism reinforced by a meeting with the company's chief executive Charles Woodhead and CFO Brad Greve.
Management's confidence stems from the bipartisan support in the US for increased defence budgets, necessary for supporting Ukraine and replenishing transferred supplies.
Moreover, a structural shift towards heightened readiness levels promises sustained higher spending.
BAE is particularly well-positioned to capitalise on this uptick in demand, says Morgan Stanley (NYSE:MS), especially from European countries.
In the near term, BAE can amplify its production output by two to two and a half times in specific lines by maximising operational capacity to a 24/7 schedule.
However, scaling beyond this level will require substantial investments in new facilities, machinery, and workforce, necessitating an 18-24 month timeframe.
Japan's commitment to double its defence budget to 2% of GDP within five years is also noteworthy, positioning it as the third-largest market globally.
BAE's involvement in the Global Combat Air Programme (GCAP) alongside Japan accentuates the company's strategic advantage in leveraging this surge in expenditure, presenting a medium to long-term upside that is currently underappreciated by the market.
Management is also exploring growth avenues through targeted acquisitions, focusing on sectors like space, autonomy and drones, particularly in the US market.
Financially, BAE anticipates ending the year with capacity for strategic acquisitions within the £100 million enterprise value range.
Longer-term, the strategy encompasses a balanced mix of dividends, bolt-on mergers and acquisitions (M&A), and share buybacks.
BAE also expects modest margin expansion, driven by a favourable product mix and the transition of development programmes to full production rates.
Overweight with a 1,450p target is Morgan Stanley’s investment view.