How Will BAE Systems Plc Fare In 2014?

For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at defence, aerospace and security company BAE Systems (LSE: BA) (NASDAQOTH: BAESY. US).

Track record

With the shares at 413p, BAE Systems’ market cap. is £13,276 million.

This table summarises the firm’s recent financial record:

Year to December 2008 2009 2010 2011 2012
Revenue (£m) 16,671 20,374 20,980 17,770 16,620
Net cash from operations (£m) (1,095) 1,630 962 482 2,173
Adjusted earnings per share 37.1p 40.1p 39.8p 45.6p 38.9p
Dividend per share 14.5p 16p 17.5p 18.8p 19.5p

1) Prospects

It’s clear from the table that revenue has been shrinking at BAE Systems. Continuing uncertainty in government defence budgets in the company’s biggest markets, the UK and the US, hasn’t helped. The firm is £134 million through a £1bn share repurchase programme, which it expects to take three years to complete, as long as negotiations over a price-escalation agreement relating to the Typhoon are successful. Such a programme should help to prop up investor returns.

In a recent third-quarter update, the directors said that benefit from the share-repurchase programme should lead to double-digit growth in underlying earnings per share for 2013, despite revenue downside caused by US defence budget cuts.

The firm supplies “life’s” essentials, such as fighter planes, radar, attack missiles, warships and munitions and, aside from the large US and UK markets, BAE is seeing what it calls vibrant activity internationally, such as an order from the United Arab Emirates for the supply of Typhoon aircraft and other services. £5bn worth of non-UK/US orders has hit the firm’s ledger so far this year. To put that in perspective, BAE’s turnover last year was almost £18bn.

2) Risks

In today’s often-troubled global environment, it’s difficult to see the firm’s offering losing its demand. However, national defence budgets tend to fluctuate according to macro-economic conditions. So there’s an element of cyclicality to the shares.

BAE Systems isn’t multi-bagging material in my view, but the constant nature of the business makes me optimistic about the ability of cash flow to support a steady dividend.

The firm derives much of its revenue from a relatively small number of sovereign-government customers. There is a risk, then, that these large customers hold pricing and other powers. Indeed a simple change of policy in, say, the US could scupper the firm’s financial performance in any trading period.

3) Valuation

City analysts are expecting earnings to twice-cover a dividend yielding 5% in 2014.

Meanwhile, the forward P/E ratio is running at around 10, which looks like a fair price, even though predictions are for a 2% earnings-per-share slide.

What now?

I think BAE Systems’ dividend prospects look attractive. The firm has a history of dividend raising, which it will be reluctant to break. If cash flow holds up, there’s every reason to suppose that the dividend progression will continue.

The firm is going on my list of dividend possibilities alongside an idea from one of the Motley Fool’s top value investors who has discovered what he believes is one of the most alluring income-generating share-plays on the London market. What’s more, it doesn't depend on war and hostility to thrive.

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> Kevin does not own shares in BAE Systems.