BAE Systems (LSE: BA) is set to benefit from a number of favourable tailwinds this year. Despite rising global economic uncertainty, defence spending is rising across Europe and the Middle East on concerns over regional stability and increasing geopolitical tensions. Moreover, the recent fall in the value of the pound against the dollar would make exports cheaper and boost the sterling value of BAE’s foreign currency earnings.
Notwithstanding the favourable near-term outlook, the stock is a great income pick for two key reasons. Firstly, due to its strong backlog of orders (around £36bn at the end of June), the company has a high degree of certainty over its future revenues. Secondly, BAE earns nearly half of its revenues from service and maintenance contracts, which produce a steady, predictable, low-risk revenue stream over a long period of time.
The company yesterday reiterated its guidance for underlying earnings per share to be between 5% and 10% ahead of last year. Shares in BAE currently yield 3.9% and trade at a forward P/E of 13.3.
Brexit worries
Earlier this week, outsourcing firm Capita (LSE: CPI) warned that the UK’s decision to leave the EU could have a material impact on its top-line growth.
Chief executive Andy Parker said: “While it is too early to know the impact of the recent EU referendum, it has created increased uncertainty, particularly in the financial services sector, and we are continuing to experience some delays in decision making in the short term.”
Sales growth may slow in the short term following Brexit, but the company is doing well at what it can control. Capita is a leader in the UK outsourcing industry, with its scale and unique breadth of capabilities giving it a strong competitive advantage. So far this year, Capita secured some £879m worth of contract wins, bringing its total bid pipeline to £5.1bn. Sales increased 5% year-on-year to £2.4bn in the first half of 2015, while pre-tax profits rose 27% to £186.1m.
Furthermore, with dividend cover of 2.2 times, there’s a compelling case for steady dividend increases over the coming years. Shares in Capita currently yield 3.4%, and investors can look forward to a forecast 6% increase this year.
Cyclical risks
It’s been a bad month for domestic UK stocks and as expected, Stagecoach’s (LSE: SGC) share price has taken a beating. Shares in the rail and bus company have sunk 19% since the Brexit vote due to uncertainty surrounding the UK’s economic outlook and the potential consequences for the transport sector.
Typically, the transport sector’s profitability is highly correlated with economic cycles. Whenever economic activity slows, rail and bus passenger numbers fall, and so too do margins and profits. And in addition to risks over slowing economic growth, Stagecoach could face a number of structural issues, including increased competition.
In rail, the transport regulator has allowed a competing service between London and Edinburgh to begin from 2021, in direct competition with its Virgin Trains-branded East Coast service.
Nevertheless, Stagecoach’s income prospects seem secure and highly tempting. The stock currently yields 5.5%, with 2.4 times dividend cover in 2015. And despite expectations of shrinking earnings, City analysts expect only a modest reduction in earnings – adjusted EPS is forecast to fall 8% and 3% over the next two years. So, even if management maintains its progressive dividend policy, forward dividend cover would likely still exceed 1.9 times by 2017.
