The Risks Of Investing In BAE Systems plc

Today I am highlighting what you need to know before investing in BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US).bae

Brittle conditions on the Western front

Arms builder BAE Systems and its industry peers have for generations benefitted from a steady stream of armed conflicts raging across the globe.

And with the Ukraine crisis fanning fears of a new Cold War between East and West; the march of Islamist rebels ISIS prompting rising military involvement from the US and Europe; and China becoming increasingly engaged in territorial disputes with its Asian neighbours, it seems that demand for BAE Systems high-tech weaponry looks set to remain very much in demand.

However, investors should be concerned that the still-fragile state of critical Western economies could still result fresh waves of bottom-line pressure for the world’s defence sector.

Indeed, BAE Systems cautioned in last month’s interims that “in the US, some limited trading disruption is likely in the last quarter of the 2014 calendar year” as Washington scrambles to meet this year’s defence spend target.

I have previously argued that the recent financial troubles in North America and Britain which prompted military spending scalebacks and lumpy contract timings would pass as the economic recoveries in these regions clicked through the gears.

But with signs that extreme financial difficulties are once again rearing their head in the eurozone — regional powerhouse Germany is now on the brink of recession — and economic cooling continuing on the world’s shop floor of China, the implications of these problems on the US and UK could seriously jeopardise the long-term sales outlook for the likes of BAE Systems.

Dividend growth in jeopardy?

Given this worrying macroeconomic outlook for the firm’s main customers, BAE Systems’ reputation as a bubbly dividend stock may also come under pressure should earnings growth stall.

According to City forecasts, the defence giant is expected to shell out payments of 20.4p and 20.9p per share for 2014 and 2015 correspondingly, representing year-on-year growth of 1.5% and 2.5%.

If realised, these figures are down markedly from a compound annual growth rate of 5.9% for the previous five-year period. And projected payouts for 2014 and 2015 boast dividend coverage of 1.9 times prospective earnings, just below the safety benchmark of 2.

This value is by no means catastrophic, of course. But with debt levels continuing to edge higher, and the firm also engaged in a mammoth three-year, £1bn share repurchase programme, the spectre of sustained earnings pressure could severely harm dividend growth in the medium to long term.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.