What should investors in BAE Systems (LSE: BA) be worried about?
Defence contractor BAE Systems (LSE: BA) is a business with very definite attractions. A £10 billion FTSE 100 (UKX) constituent, the company is expected this year to deliver revenues of £19 billion.
Better still, the company is attractively priced, as well: with its shares changing hands today at 305p, BAE is rated on a prospective price-to-earnings (P/E) ratio of just under 8, offering a dividend yield of 6.5%.
But how safe is that share price? And -- critically important for income investors -- how safe is that dividend? In short, how could an investment in BAE adversely impact investors' wealth?
In this series, I set out to answer just these questions. My starting point: BAE Systems' latest annual report, where the company's directors are obliged to address the issue of risk.
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of BAE Systems' size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are these risks?
Read the small print, and BAE identifies no fewer than 10 risks as having a 'high impact' on the company's financial performance. They range from competition and pension funding, to the nature of its markets and various contractual provisions.
So let's take a look at three of the biggest.
Defence spending cutbacks
BAE is exposed to a small number of national markets -- principally, the United States, the UK, Saudi Arabia and a handful of other countries, including Australia and India. According to BAE:
"With constraints on government expenditure in a number of the Group's markets, and countries in the eurozone area currently experiencing serious financial difficulties, affordability continues to be a key focus for customers."
How is it addressing that risk? First, it isn't panicking, noting that the British and American governments remain committed to protecting the size and strengths of their fighting forces. Second, it's implementing cost-cutting measures and growing its services business, which is less exposed to budgetary cutbacks.
Some of BAE's businesses depend on a handful of very large contracts. As the company puts it:
"A significant proportion of the Group's revenue comes from a small number of large contracts. Each of these contracts... is typically worth or potentially worth over £1bn. The loss, expiration, suspension, cancellation or termination of any one of these large contracts, for any reason, could have a material adverse effect on the Group's future results and financial condition."
Mitigation, the company notes, takes the form of maintaining a well-balanced spread of programmes and a large forward order book, coupled to regular reviews and close monitoring.
Fixed price contracts
Finally, fixed-price contracts are an important concern. As BAE notes:
"A significant portion of the Group's revenue is derived from fixed‑price contracts. An inherent risk in these fixed-price contracts is that actual performance costs may exceed the projected costs on which the fixed prices for such contracts are agreed."
How are such risks dealt with? Broadly speaking, by trying to avoid high-risk R&D contracts, limiting fixed-price production contracts, and by having "robust bid preparation and approvals processes" in place.
Risk vs reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend reinvested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All-Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Mr Woodford largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
> Malcolm owns shares in BAE Systems.