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BAE Systems Plc’s 2 Greatest Weaknesses

baeWhen I think of defence, aerospace and security company BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.

1) Large customers

Customers don’t tend to buy fighter jets and the like in ones and twos, and there’s a limited customer base centred mainly on sovereign governments. That means that BAE Systems’ £42.7bn order book is stuffed with big multi-million pound orders from a relatively few big-spending customers. There’s risk in a situation like that, with a disproportionate amount of economic power in the hands of the firm’s customers, rather than in the hand of BAE Systems’ management.

A change of buying policy in the US or UK governments, two of the firm’s big customers, could torpedo the firm’s financial performance in any trading period. Defence budgets remain uncertain around the world as austerity cuts continue to bite. At BAE Systems, we can see evidence of that in the revenue record:

Year to December 2009 2010 2011 2012 2013
Revenue (£m) 20,374 20,980 17,770 16,620 16,864

That’s a flat-looking performance, but the firm is part way through £1bn share-repurchase programme, which it expects to help to prop up earnings- and dividend-per-share figures and therefore investor returns, going forward.

2) Cyclicality

As we can see, when macro-economic times get tough, BAE systems’ business tends to shrink. Naturally that tends to reverse when economies are booming, but a boom like the last one seems years, perhaps decades away if it will occur at all.

I think as investors we should remain mindful of the inherent cyclicality in BAE’s business activities. If things get too tough out there, it’s conceivable that the firm will trim back its dividend despite a long record of raising it.

What now?

Despite such concerns, BAE Systems’ valuation seems reasonable. At a share price of around 407p, the forward P/E rating is running at about 10 for 2015 and the dividend is yielding around 5.2%. The firm released a steady-as-she-goes trading statement on 7 May and investors can expect a further update with the interim results due on 31 July.

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Kevin does not own any BAE Systems shares.