This Week’s Top Blue-Chip Income Buy: BAE Systems plc

I’m always on the lookout for big FTSE 100 companies when they’re being offered in the market at an attractive valuation for dividend investors. A little higher yield at the time you buy can make a big difference to the growth of your income stream over the long term.

Right now, I reckon BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) is looking a great buy for income.

BAE hasn’t been immune to government cuts in UK and US defence budgets. Nevertheless, the company has an order backlog representing over two years of sales; and, in the absence of a magic wand to end human conflict the world over, I expect demand for BAE’s products to continue well into the future.

A great opportunity right now

The table below shows the five biggest FTSE defence and aerospace firms ranked by trailing 12-month dividend yield.

  Market cap Recent share price Dividend yield
BAE £15bn 457p 4.3%
Cobham £3bn 284p 3.2%
Meggitt £4bn 516p 2.4%
Ultra Electronics £1bn 1,951p 2.1%
Rolls-Royce £23bn 1,210p 1.7%

In what is a low-income sector, BAE’s yield stands out like an aircraft carrier in Regent’s Park lake.

It is the board’s policy to pay dividends in line with “long-term sustainable cover of around two times underlying earnings”. For 2012, BAE delivered a 19.5p dividend, twice covered by underlying earnings per share (EPS) of 38.9p.

In a trading update last month, management told us that “double-digit growth in underlying earnings per share is anticipated for 2013” — guidance that assumes a satisfactory completion before the year end to negotiations on the pricing of a Saudi Arabia jet fighter contract. If negotiations were to go beyond the end of the year, EPS for 2013 “would be impacted by approximately 6 to 7 pence”.

Assuming dividend cover of two, the former case would give us a full-year dividend of around 21.5p (+10%) and the latter would give us a dividend of around 18p, which would represent an 8% cut.

Whatever the outcome, I’m certain in my own mind that we won’t see a dividend as high as 21.5p or as low as 18p. The board lifted this year’s interim dividend by 2.6%, and I can see an inflation-pacing full-year dividend — say 20p — whether the Saudi negotiations are concluded or not. Such a payout would imply dividend cover of 2.1 or 1.8 depending on which outcome prevails — both numbers being within the cover policy of around two times underlying earnings.

The defence and aerospace sector provides useful diversification. I rate BAE, with its current sector-leading 4.3% yield, as a great buy for long-term income investors right now.

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> G A Chester does not own any shares mentioned in this article.