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2 Worrying Reasons To Steer Clear Of BAE Systems plc

In recent days I have looked at why I believe BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) is poised to soar in coming years (the original article can be viewed here).

But, of course, the world of investing is never black-and-white business — it take a confluence of views to make a market, and the actual stock price is the only indisputable factor therein. With this in mind I have laid out the key factors that could, in fact, drive BAE Systems’ share price through the floor.

US military downsizing threatens earnings outlook

BAE Systems’ top-tier supplier status to Western militaries helps to safeguard it against the worst of defence cuts and keep the contracts rolling in. On top of this, the company’s concerted effort to court fast-growing customers in emerging geographies is also helping to boost its long-term earnings outlook.

baeAnd the defence giant breathed a huge sigh of relief in December when US Congress signed a bill to head off massive cuts to the defence budget this year and next. However, BAE Systems warned that despite the subsequent improvement to near-term visibility, “pressures to reduce spending and address the US deficit are expected to continue.”

Indeed, news last month that Defence Secretary Check Hegel plans to downsize the US Army to between 440,000 and 450,000 troops, down from 520,000 presently, underlines the uncertainty which BAE Systems and its peers still face over future demand for their weapons and systems. These cuts will reduce the US Army to its smallest level since World War Two.

Beware of a lightening wallet

Another concern for BAE Systems is a significant decline in the firm’s cash position. The defence specialist saw free cash flow plummet to just £137m in 2013, a mammoth drop from £3.12bn during the previous twelve-month period, mainly due to a 50% decline in operating profit — to £806m — and huge swings in working capital.

Given the vast amounts of R&D capital the company needs to stay at the cutting edge across a multitude of aerospace and defence technologies, this has raised questions over whether the business can keep dividends rolling at the breakneck speed of previous years. And with the BAE Systems also having to fund the pension deficit, the potential for a flurry of fresh acquisition activity could also be compromised.

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Still, BAE Systems remains favourite for income investors owing to its long history of offering reliable and generous dividend growth. Indeed, projected payments of for 2014 and 2015 create yields of 5.1% and 5.2% respectively, far ahead of the 3.2% FTSE 100 average.

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Royston does not own shares in BAE Systems.