Will BAE Systems plc Be Forced To Slash The Dividend?

Today I am looking at why BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) could be a risky income play.bae

Payment growth predicted to keep moving

In spite of enduring earnings volatility, BAE Systems has still been a consistent deliverer of year-on-year dividend growth in recent times thanks to its strong capital base. Indeed, the business has lifted the payout at a compound annual growth rate of 5.9% since 2009, and City brokers expect the defence play to keep its progressive policy rolling.

Current forecasts indicate that the business will lift the total payout 1% during 2014 to 20.3p per share, with an extra 2.5% anticipated for the following 12-month period, to 20.8p.

As a consequence BAE Systems continues to offer above-average dividend yields, with this year’s projected payment producing a readout of 4.6% and which moves to 4.7% for 2015. By comparison the complete aerospace and defence sector carries a forward average of just 2.6%

… but dividend slowdown highlights fragile finances

But in my opinion expectations of a sharp deceleration in payout growth at the firm this year and next should serve as caution to income hunters. Like the complete defence sector, BAE Systems has been whacked by spending constraints by the US and UK governments, which has reduced order rates and resulted in contract lumpiness.

Against this backdrop BAE Systems saw turnover fall 17% last year to £18.2bn from the £21.8bn recorded back in 2009. And further travails at the top-line are anticipated to cause a 10% earnings slippage this year, although a modest 6% bounceback is predicted for 2015.

These projections mean that dividends are covered 1.9 times by expected earnings through to the close of next year, hardly catastrophic but falling short of the widely-regarded safety yardstick of 2 times or above.

Still, investors should certainly be perturbed by rising debt levels in my opinion. BAE Systems saw net debt rise fall fractionally during January-June from the corresponding 2013 period, to £1.2bn. But this is a sharp jump from debt of £700m recorded at the turn of the year.

And of course BAE Systems has to fork out vast sums for organic investment as well as acquisitions to remain at the cutting edge of weapons design and kickstart its growth prospects. Just last week the firm chucked £144.4m to acquire SilverSky, a global player in the rapidly-expanding cyber security sector.

But with challenging economic conditions set to persist across its key Western markets, BAE Systems’ deteriorating balance sheet could prohibit the firm from maintaining its positive dividend policy in coming years.

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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.