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The Hidden Nasty In BAE Systems plc’s Latest Results

BAE Systems

Another day, another profit warning. Hot on the heels of Rolls-Royce’s surprise warning that growth would pause in 2014, last week saw BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) announce that earnings per share are expected to fall by up to 10% in 2014.

The reasons given were continuing US defence spending cuts, and the ‘non-recurring benefit’ from the long-running Salam price negotiation, which relates to a 2007 agreement to sell 72 Eurofighter Typhoon aircraft to Saudi Arabia.

The interesting thing about the Salam negotiations is that BAE had previously said that failure to reach an agreement in 2013 would reduce earnings per share by around 6-7p. What wasn’t so obvious was that US spending cuts would mean that the firm’s earnings were going to fall, regardless of the Salam deal. All that the Salam deal has done is to delay this year’s fall in earnings to next year.

BAE now says that it expects the value of its North American business to fall by 15%, and I believe these sales could be hard to replace.

Falling new business?

The US accounts for 44% of BAE’s business, so a reduction in its dependency on North America seems desirable. The problem for BAE is that there aren’t many comparable alternatives; apart from the UK and the US, most of the world’s biggest defence spenders (Russia, China, France) are fiercely loyal to their home-grown defence industries.

Two potentially big aircraft orders, from India and UAE, have gone to France this year, and while the firm has a list of prospective smaller buyers for its Typhoon aircraft, I reckon that the best the firm can hope for is to replace the lost US revenue with a number of smaller orders for Typhoons and other equipment — outright growth over the next two years seems unlikely.

BAE’s order book remained more or less unchanged in size last year, but its intake of non-UK/US orders fell by 17%, as the one-off boost provided by the £2.5bn order from Oman for 20 aircraft in 2012 fell out of the figures:

Year Non-US/UK Order intake Total order book
2011 £4.8bn £39.1bn
2012 £11.2bn £42.5bn
2013 £9.3bn £42.7bn

Source: BAE Systems company reports

In my view, BAE shareholders should prepare for a few years of slow or non-existent growth. I don’t believe that the UK or US defence markets are likely to shrink much further, but BAE’s forecast P/E of 10.6 might now be a fair rating for a firm whose growth prospects appear limited.

Still a cracking dividend...

Despite BAE's expected earnings slowdown, the firm remains highly profitable and generates strong, albeit very lumpy, cash flow. As a result, I don't believe that BAE's 5% prospective yield is in danger.

However, ultimately it's your decision, and before you buy BAE shares, I would strongly recommend you test its dividend against the five 'golden dividend rules' described in "How To Create Dividends For Life", the latest special report from the Motley Fool

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> Roland owns shares in BAE Systems but not in any other company mentioned in this article.