Is the booming BAE Systems share price a deadly trap?

After a disappointing 2024, the BAE Systems (LSE: BA.) share price is rising at speed.

The FTSE 100 defence manufacturer’s shares have rocketed 28% in the last month and are up 23% over the past year.

Investors are piling in, buoyed by concerns over Russia’s ongoing war in Ukraine and Donald Trump’s radical shift of US foreign policy,as he pressures European nations to ramp up their military spending.

European-listed defence contractors, including BAE Systems, have been major beneficiaries but have they rallied too far, too fast?

What next for this FTSE 100 stock?

We’re seeing seismic changes. Germany is now considering scrapping its self-imposed debt brake to fund a large-scale military rebuild. The UK is also pushing for increased defence spending, albeit at a more modest level.

This is happening at a time when BAE Systems is already in an enviable position. Full-year results, published on 19 February, showed sales soared 14% to £28.3bn in 2024. Underlying profit grew by a similar percentage to £3.02bn.

Even better, the company’s order backlog hit an all-time high of £77.8bn, up 11% year on year. That should provide stunning revenue visibility for years to come.

Investors were also treated to a 10% dividend hike. The trailing yield is a modest 2.1%, but would be much higher if the shares hadn’t grown so fast.

However, there was a slight concern in the results: free cash flow slipped by £88m to £2.51bn, which could be something to watch.

Despite BAE’s success, there are risks. While Europe is accelerating defence spending, Trump has signalled potential cuts to the US military.

Given that BAE generates around 45% of its revenues from the US, any shift in Pentagon spending could hit orders.

Also, while European governments have made ambitious promises, following through is another matter.

The UK, for example, has pledged only a modest increase in defence spending and remains financially constrained. If economic conditions worsen, budget priorities could shift away from military expansion.

The P/E ratio is a little high

There’s also the wildcard factor of peace talks. If discussions around the hoped-for Russia-Ukraine ceasefire gain traction, governments might seize the opportunity to scale back spending.

The BAE Systems share price, which has surged on expectations of long-term conflict-driven demand, could slip if we see meaningful progress (although I don’t think we will, much as we long for it).

I have another worry. The shares are a little expensive with a price-to-earnings (P/E) ratio of more than 23. Investors are pricing in a lot of growth here.

Defence stocks have historically been cyclical, and while the world is currently in a period of heightened military investment, events can turn quickly. Investors considering buying BAE Systems today should proceed with caution.

The fundamentals are strong, the outlook promising and I still think this is a brilliant long-term buy-and-hold. I’m just worried that today’s rally has already priced in a best-case scenario. To be clear, I have absolutely no plans to sell my shares. I just won’t add to my position at today’s price.

The post Is the booming BAE Systems share price a deadly trap? appeared first on The Motley Fool UK.

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Harvey Jones has positions in BAE Systems. The Motley Fool UK has recommended BAE Systems. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.