BAE Systems’ dividend yield is high, but is it good value? – The Property Chronicle
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BAE Systems’ dividend yield is high, but is it good value?

The Fund Manager

BAE Systems is an obvious choice for dividend investors.That’s because: 

(1) BAE Systems is the UK’s largest defence manufacturer which should make it a relatively defensive company (governments may cut defence spending during recessions, but cuts are not usually drastic).

(2) BAE has a long track record of dividend growth, with the dividend going from 9.2p in 2003 to 22.2p in its 2018 results.

(3) BAE has a decent dividend yield of 4.7% at its current price of 458p.

However, BAE also has a few features which make it less attractive than it might at first appear.

BAE’s dividend growth is not matched by earnings or revenue growth

Long-term dividend growth is almost a requirement for attractive dividend-based investments, but dividend growth alone is not enough.

That’s because dividend payments must be covered by earnings, which are extracted from revenues, which come from customers paying for products or services, which are produced using the assets of the business (e.g. factories, warehouses and stock), which are paid for with shareholder and debt holder capital.

So if earnings, revenues and capital employedare not going up then any dividend growth will eventually hit a ceiling.

With that in mind, the previous chart shows several things:

(1) BAE’s revenues have gone essentially nowhere for a decade.

(2) BAE’s earnings also show no obvious growth trend.

(3) BAE’s capital base (i.e. capital employed) shrank following government cutbacks after the global financial crisis. This came about through a mixture of business writedowns, disposals and ‘rightsizings‘. After 2014 the company’s capital base has returned to growth, but this a relatively short period and has yet to drive consistent revenue growth.

(4) BAE’s dividend has continued to grow every year, but the rate of increase has slowed from more than 5% per year to less than 2% per year today.

This lack of consistent broad-based growth is not the end of the world and I wouldn’t rule out investing in BAE because of this alone. But averaged across capital employed, revenues and dividends, its growth has failed to match inflation over the last decade, and that has to be reflected in the purchase price.

BAE’s dividend cover is wafer thin

An uncovered dividend is a classic sign of a dividend under threat, so having earnings that consistently cover the dividend is important.

In BAE’s case, its progressive dividend growth and lack of earnings growth has given the company an average dividend cover over the last ten years of just 1.2.

In other words, the company has paid out 85% of its earnings over the last ten years as a dividend, and that’s a problem for a couple of reasons:

(1) The margin of safety between earnings and the dividend is relatively thin, so any small but prolonged decline in earnings is likely to put the dividend under severe pressure.

(2) With just 15% of earnings being retained, BAE may find it hard to increase its investment in productive capital assets such as offices, factories and machinery (often called property, plant and equipment) in order to drive future growth.

This isn’t necessarily a disaster waiting to happen, but thin dividend coverage and the related squeeze on growth investment should also be reflected in the price.

BAE’s profitability is just about acceptable

I have two rules relating to the returns a company makes:

(1) Only invest in companies that have a ten-year average net return on sales above 5%

(2) Only invest in companies that have a ten-year average net return on capital employed above 10%

The first rule looks at net return on salesbecause I want to measure the margin of safety between a company’s income and its expenses. For example:

Imagine a company with a net return on sales of 2%. This means it has expenses of 98p for every pound of revenues, so it has just 2p per pound to act as a buffer, or margin of safety, between income and expenses.

Any rise in expenses must immediately be passed onto the customer, otherwise the thin profit margin could disappear and turn profits into losses very quickly.

The same applies to a small decrease in the price customers are willing to pay for the company’s goods or services. Expenses would have to be cut rapidly, otherwise the wafer-thin profit margins would be wiped out in no time.

Some companies can cope with thin profit margins much more easily than others. These are typically companies that earn a relatively fixed percentage on the cost of goods or services sold, such as energy suppliers or product distributors. Even so, thin profit margins are generally not a good sign.

In BAE’s case, over the last decade it produced total net profits of £7.7 billion, which is a lot. However, it took total revenues of £177.8 billion to generate those profits, giving an average net return on sales of 4.3%. That’s below my 5% floor, which is enough to set off some mental alarms.

Somewhat more optimistically, its return on sales has averaged 5.2% over the last five years, but that is still barely above my minimum standard.

To generate those profits, which average out to £766m in each year, BAE employed capital from shareholders averaging £4 billion and capital from debt holders averaging £3.6 billion. So BAE’s average capital employed was £7.6 billion, and that capital produced average net profits of £766m, giving an average return on capital of 10.2%.

A return on capital employed of 10.2% is barely above my minimum standard of 10%, and by that measure BAE is a very average company.

Having said that, the company’s capital structure is clouded somewhat by two very large balance sheet items: £10 billion of acquired goodwill and a £4 billion pension deficit.

Acquired goodwill clouds the profitability picture

The acquired goodwill (which is the amount paid for an acquired company above and beyond its net tangible assets) was mostly added to the balance sheet between 1998 and 2008 when BAE spent upwards of £10 billion buying other companies.

Over the same period the company generated a total of £4.3 billion in net profit, so spending £10 billion on other companies was a very ‘enthusiastic’ way to run the business. It’s what I call an acquisition spree, in this case funded by debt holders (via an additional £2.5 billion of debt) and shareholders (via a 70% increase in the number of shares).

Acquired goodwill makes it harder to see what sort of return a company might get on any earnings which are invested directly (i.e. organically) into tangible assets such as property, plant and equipment. And that’s important because companies with strong competitive advantagescan typically earn above average rates of return on tangible assets.

For example:

Imagine a company with one factory which it built for £100 million. The company has strong competitive advantages and its factory produces profits of £40 million per year, giving a very high return on capital of 40%.

If another company then acquires that first company for £500 million, the acquirer will have a £100 million tangible asset on its balance sheet (representing the factory) and a £400 million intangible asset (the acquired goodwill).

The acquirer will still get £40 million of profits annually from this factory, but its return on capital employed is a far less attractive 8% (£40m per year from a £500m investment), purely because of the price it paid to buy the factory.






The Fund Manager

About John Kingham

John Kingham

John Kingham is the editor of UK Value Investor, the investment newsletter for defensive value investors. With a professional background in software analysis, John's approach to high yield, low risk investing is based on the Benjamin Graham tradition of being systematic and fact-based, rather than speculative. John is also the author of The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio. His website can be found at: www.ukvalueinvestor.com.

Articles by John Kingham

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