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Why I’m avoiding these two blue chip dividend stocks

Photo: Krasimir Grozev. Cropped. Licence: http://creativecommons.org/licenses/by-sa/3.0

Blue chip stocks are generally considered to be the market’s safest investments thanks to their size, heritage and multi-billion pound revenue streams. However, just because they’re generally perceived to be safe, doesn’t mean they’re not immune to the same pressures as other businesses, such as disruption and the economic environment. 

And as we’ve seen with Capita and Pearson over the past 12 months, even the market’s most established businesses aren’t immune from a sudden change in business activity. Investors are usually the last to find out.  

But it’s not just a change in operating conditions that can spell the downfall of a blue chip, it’s also debt. 

Toxic for business

Debt is toxic for business and high levels of it can be extremely debilitating. There are thousands of cases where a business has tried to grow too fast, taken on too much debt and plummeted to earth.  Many of these companies would have survived if they’d just stayed away from leverage. 

Pension problems 

BAE Systems (LSE: BA) is one of the most indebted companies in the FTSE 100. The company’s gross gearing is 170% and net gearing is 75% thanks to the group’s £2.5bn cash pile. But it’s not really the size of BAE’s debt that’s concerning, it’s the speed at which the company has got to this position. 

Indeed, at year-end 2012, BAE reported a net cash balance of just under £500m. At the end of June 2016, BAE’s debt had ballooned to just over £2bn. This implies the company is adding around £500m in debt per annum. 

What’s more, BAE has one of the largest pension deficits in the FTSE 100. At the end of June, the company reported a pre-tax accounting net pension deficit of £6.1bn. To put that into some perspective, for the first half of 2016, it reported a net profit of £420m. The firm is currently putting £300m per annum aside to boost its pension coffers but over the long term this is unlikely to be enough. Including pension obligations, BAE’s net gearing is 320%. 

With so much debt hanging over the company, it might be best to avoid it. Star fund manager Neil Woodford has already sold his stake in the defence group, citing pension concerns. 

Debt levels exploding 

British American Tobacco (LSE: BATS) is viewed by many as the ultimate defensive stock but with debt growing and sales of its main product declining, the company may not be as defensive as many believe it to be. 

At the end of 2015, it had a net gearing ratio of 300%. Ratings agency Moody’s believes after acquiring US peer Reynolds, the company’s gearing could explode by 50% to 460%. With interest rates at all-time lows, management may believe this level of debt is sustainable, but what happens when interest rates rise? Moreover, last year British American paid out 85% of its operating cash flow to shareholders via dividends, leaving little room for debt repayment. 

When you also consider that the sales of cigarettes are falling, it makes you wonder how much longer the company can continue on its current course. Even though its dividends might seem appealing, it could be best to avoid it. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.