When we think of all the trouble in the world it seems intuitive to imagine that the defence sector might throw up a few firms capable of delivering steady investment returns.
BAE Systems (LSE: BA) (NASDAQOTH: BAESY. US) is one outstanding British success story in the industry that supplies some of the world’s finest and most effective fighter planes, radar, attack missiles, warships and munitions. Â
However, in terms of its credentials as an investment proposition, the firm still has a few unpolished surfaces, so it seems important to time an investment with care.
Cyclicality
Demand varies for BAE Systems’ products. The majority of the firm’s roughly £43 billion order book relies on three big sovereign government customers, which meansa change in defence -spending policy in the US, UK or Saudi Arabia could change the trading outcome for BAE Systems in a jiffy.
Naturally, governments balance their budgets according to their means, which translates into  cyclical financial results for the likes of BAE Systems as macro economic conditions fluctuate:
|
Year to December |
2009 |
2010 |
2011 |
2012 |
2013 |
|
Revenue (£m) |
20,374 |
20,980 |
17,770 |
16,620 |
16,864 |
|
Adjusted earnings per share |
40.1p |
39.8p |
45.6p |
38.9p |
42p |
Revenue has fallen and earnings have remained flat over the last five years. If we look at BAE Systems’ share-price chart we see some big swings, and that means cyclicality is capable of causing capital fluctuation to wipe away dividend income gains. For that reason, an investment needs very careful timing.
Outlook
Last year, 37% of the firm’s sales were to the US, 26% to the UK and 20% to Saudi Arabia. As those regions are so critical to the firm’s on-going success it’s encouraging to learn from BAE Systems’ chief executive that  long-term, stable contracts in the maritime and military air sectors in the UK continue to support the company’s operations, providing forward earnings’ visibility.
He also says the firm is making progress in other international markets but, last year, international sales outside the big three regions only scored 17% of the total, so the buying actions of the US government matter a lot. Luckily, after a long period of spending constraint, demand from across the pond seems set to stabilize. With the US still effectively policing the world, it’s hard to see their military spending trailing off, although a change in policy with regard to their preferred suppliers could hurt BAE Systems, no doubt.
Volatile cash flow
When it comes to the firm’s ability to pay a dividend, it’s cash that counts and the five-year record of cash generation could best be described as volatile. Despite that, the company seems to put the dividend up every year:
|
Year to December |
2009 |
2010 |
2011 |
2012 |
2013 |
|
Net cash from operations (£m) |
1630 |
962 |
482 |
2,173 |
(110) |
|
Dividend per share |
16p |
17.5p |
18.8p |
19.5p |
20.1p |
I’m not an expert on the contract terms and conditions within the agreements that BAE Systems signs up to for supplying fighter jets and the like, but I have worked on large contracts in other industries and know that a supplier can end up waiting a terribly long time for payment monies to materialise. Perhaps that’s a factor in BAE Systems wildly fluctuating cash flow.
What now?
In the hunt for reliable and growing dividend income, BAE Systems remains low on the list of choices, for me. I’m worried about the potential for a fluctuating share price to wipe out hard-won dividend gains thanks to cyclicality, and also about the firm’s reliance on just a few large customers — the firm’s outlook could change practically overnight if it somehow falls from favour with one of the big three.