Defence giant BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) is a core element of many investors’ income portfolios — including my own.
The firm’s share price performance has matched that of the FTSE 100 over the last five years, climbing by around 45%, but BAE’s high yield has helped the defence giant beat the index, with BAE delivering an average total return (capital gains plus dividends) of 11.9% per year, compared to 11.1% for the FTSE 100.
However, BAE’s dividend could be losing its shine: the firm is only expected to increase its payout by 1.4% this year, and by 2.4% next year.
Problems?
Let’s start with the basics: how is BAE valued against its historic and forecast performance?
|
P/E ratio |
Current value |
|
P/E using 5-year average adjusted earnings per share |
11.1 |
|
2-year average forecast P/E |
12.0 |
Source: Company reports, consensus forecasts
On the face of it, BAE looks very reasonably priced, especially given its 4.4% prospective yield.
However, BAE has been struggling to grow in recent years, thanks mainly to budget cutbacks in the UK and US — the firm’s two biggest markets.
Is BAE cheap because it’s a business that’s stagnating — or shrinking?
Fundamental shrinkage
A closer look at BAE’s accounts from the last five years suggests that BAE’s business may indeed be shrinking slightly:
|
5-year compound average growth rate |
Value |
|
Sales |
-3.6% |
|
Underlying earnings |
-2.6% |
|
Underlying earnings per share |
1.4% |
|
Dividend |
+4.7% |
Source: Company reports
Annual turnover has fallen by an average of 3.6% per year since 2009, while underlying earnings (defined by the firm as earnings before interest, taxation and amortisation, or EBITA), have fallen by an average of 2.6% per year over the same period.
Investors have been consoled with dividend growth averaging 4.7% per year, but the apparent annual growth in the firm’s underlying earnings per share should be treated with caution: it contradicts BAE’s falling profits, and is mainly the result of the company’s ongoing share buyback programme, which totalled £212m in 2013 alone.
Uncertain outlook
I don’t think BAE’s problems are bad enough to warrant selling the stock, but I only rate it as a hold at present, not a buy.
One of my concerns is that City consensus forecasts for the firm’s earnings have been downgraded steadily this year: the current forecast, for earnings per share of 37.6p in 2014, is almost 5% lower than it was just three months ago.
In my view, BAE’s shrinking sales and profits are a warning that the current share price might not be as cheap as it seems. I believe it might pay to wait a little longer, before buying any more of the firm’s shares.