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Why BAE Systems plc is one of the most underrated dividend stocks around

For the past 24 hours, press focus has been on the decision by BAE Systems (LSE: BA) to slash nearly 2,000 jobs from its domestic manufacturing base… and what this says about the future of defence contractors and related production in the UK.

A new, shareholder-friendly attitude 

However, lost in the noise is that this decision, although dramatic and likely to lead to fightbacks from unions and politicians, is helping to set up BAE as a forward-looking, shareholder-friendly company.

This is especially true when it comes to income investors, who I believe will find BAE’s solid, if not spectacular, 3.5% dividend yield a welcome relief in this low-yield world. The company’s dividend payouts have been growing steadily in recent years even as defence budgets in major markets were stuck in the doldrums post-Iraq war, which is a sign of a rational and sustainable dividend payout policy.

And this once dire outlook is beginning to turn around as the US Senate has recently passed a new $700bn defence spending bill that was actually larger than what Donald Trump even asked for. As the US has been BAE’s largest market by a large margin so far in 2017, this increased spending will a boon for the business.

Double-digit spending increases in its biggest market, together with a renewed focus from management on cutting costs and positioning the business for long-term growth, is a great combination for investors. Sadly, this business reorganisation has caused job losses in the UK, but with a long-awaited order for Typhoon jets from Saudi Arabia looking like it will never materialise, management is right to begin phasing out its assembly staff.

Profits and dividends on the rise

This change to organisational structures will also help shift sales towards the group’s fast-growing and higher margin electronic systems division. In H1 2017, sales for its advanced electronics platforms rose 5% year-on-year (y/y), and underlying EBIT margins hit 14.9% – much higher than group average.  

It’s early days, but group margins are already creeping up as a whole which, together with solid sales growth, has led management to repeat its guidance for a 5-10% bump in earnings per share this year. Dividends per share will likely increase a little less than this in order to maintain dividend cover of twice earnings, but that makes sense considering management’s focus on reducing net debt and its pension deficit.

At the end of June, net debt was down from £2bn to £1.7bn y/y while its pension deficit reduced from £6bn to £5.8bn over the same period. Management expects less of a reduction in net debt this year but the group remains sanely leveraged when compared to the £1bn in operating cash flow generated last year.

BAE is unlikely to be a runaway star but steady growth and a management team intent on improving profitability speak well of the company’s long-term dividend prospects. It may not be the most exciting company, but I reckon income investors may find it a great option all the same.

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Ian Pierce has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.