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BAE Systems upgraded to 'buy' by UBS but QinetiQ and Meggitt are hit by downgrades

The big order from Qatar and the good news on the pension obligations have brightened the outlook considerably ahead of an expected UK defence spending review that holds more risk for QinetiQ than BAE
Fighter jet
BAE did not exactly soar on the upgrade, but QinetiQ and Meggitt certainly dived

UBS has been reviewing the engineering sector and has taken a shine to BAE Systems PLC (LON:BA) but turned bearish on QinetiQ Group PLC (LON:QQ).

Abandoning its neutral position to upgrade BAE to 'buy', the Swiss bank said the current valuation is undemanding following the pension agreement and confirmation of the Qatar order.

READ BAE Systems and Qatar sign around £5bn contract for the supply of Typhoon fighter aircraft

READ BAE Systems' shares soar as UK pension funds top-up proves less than expected

UBS has increased its target price from 655p to 670p and said that using the actuarial UK deficit of around £2.1bn instead of the accounting deficit of £5.2bn in its net debt calculation would add around 90p to its price target.

“We think BAE’s end market exposure is amongst the most attractive in the sector; the company is exposed to growing defence budgets in the US (36% of sales) and Saudi Arabia (21%). In the US, the NDAA has authorised US$634bn base defence spending for 2018 (+15% YoY), while the Saudi government has approved a 10% increase in the 2018 budget to US$56bn. In this context, we view BAE’s valuation as undemanding,” UBS said.

“Capitalising current earnings accounts for 96% of the current equity value, implying the market attributes little value to future growth prospects,” it added.

Meanwhile, it expects a UK defence spending review in late 2018 to result in capability cuts, but believes the risk to BAE is limited, as BAE's UK activities are “longer cycle”.

“We expect the MoD [Ministry of Defence] to reduce shorter cycle spend in the run-up to the review, but think long-term commitments may increase in the context of budget uncertainty. Although investors appear concerned about the maritime business, this accounted for just £251m EBITA [underlying earnings] in 2016 (13% of group). We assume this falls to zero in our downside scenario and still arrive at a valuation of 505p,” UBS explained.

The shares currently trade at around 576p.

“Maritime sales are split out under the new divisional structure, facilitating investors’ appreciation about the worst-case scenario to earnings,” it added.

READ: UBS upbeat on European defence sector on US valuation gap; upgrades rating for QinetiQ

Fellow defence stock QinetiQ is less likely to emerge unscathed from any UK spending review and is downgraded from 'neutral' to 'sell' with the price target declining to 215p from 226p.

QinetiQ is heavily exposed with the Ministry of Defence accounting for two-thirds of revenues.

The bank sees particular risks to the shorter-cycle Cyber, Information and Training business, which accounts for 13% of group sales.

It is forecasting slower revenue growth from the second half of this year.

Over the longer term, it thinks the need for the MoD to appear to increase efficiency could encourage further outsourcing, which might potentially benefit QinetiQ, but probably not this year.

Finally, it has also downgraded aerospace company Meggitt PLC (LON:MGGT) to 'sell' from 'neutral' and chopped the target price to 440p from 485p.

UBS believes original equipment manufacturers are likely to cut back on outsourcing, and Meggitt is heavily exposed to this trend.

Previous attempts to raise prices have resulted in customers seeking alternative suppliers, UBS claims, highlighting Meggitt's vulnerability to dual sourcing.

Shares in Meggitt were down 3.8% at 473.5p on the downgrade; QinetiQ took a bigger hit, shedding 5.2% at 215.1p.

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