BAE Systems is an obvious choice for defensive dividend investors.
(1) BAE Systems is the UK’s largest defence contractor which should make it a relatively defensive company (governments may cut back on defence spending during recessions, but typically any cuts are not drastic).
(2) It has a long track record of progressive dividend growth, with the dividend going from 9.2p in 2003 to 22.2p in its recent 2018 results.
(3) It has a slightly above average dividend yield of 4.7% at its current price of 470p.
But life is rarely that simple and BAE does have a few features which make it less attractive than it might appear at first glance.
Dividend growth is not matched by earnings or revenue growth
Progressive dividend growth is almost a prerequisite for an attractive dividend-based investment, but on its own progressive dividend growth is not enough.
In the long-run those dividend payments have to be covered by earnings. Those earnings are, in turn, generated from revenues paid into the company by customers. And customers are paying for products and services produced by the assets of the business (e.g. factories, warehouses and stock), paid for with shareholder and debt holder capital.
So if earnings, revenues and capital employed are not going up then any dividend growth will eventually hit a ceiling.
With that in mind, the chart above shows several things:
(1) BAE’s revenues per share have gone essentially nowhere for a decade.
(2) BAE’s earnings have been quite volatile, but also show no obvious growth trend.
(3) BAE’s capital base shrank for several years following government cutbacks after the global financial crisis. This shrinkage 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 be reflected in consistent revenue growth.
(4) BAE’s dividend has continued to grow every year, but the rate of increase has slowed dramatically from more than 5% per year a few years ago to less than 2% per year today.
This lack of consistent growth in anything but the dividend is not the end of the world, and I wouldn’t rule out investing in BAE because of this alone.
However, averaged across capital employed, revenues and dividends, its growth has failed to match inflation over the last decade, so that has to be reflected in the purchase price.
Dividend cover is wafer thin
One reason why BAE’s dividend growth has almost ground to a halt in recent years is that the company’s dividend has pretty much caught up with its earnings.
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 policy of 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 only 15% of earnings being retained, the company may find it hard to increase its investment in productive assets such as offices, factories and machinery (often called property, plant and equipment) in order to drive future growth.
Again, this isn’t the end of the world, but this lack of a margin of safety around the dividend and the potential squeeze on growth investment should also be reflected in the price.
Profitability is just about acceptable
I have two rules covering the returns a company makes:
The first rule looks at net return on sales (profit after tax as a percentage of revenues) because it measures the margin of safety between a company’s income and expenses. Here’s an example:
Granted, some companies can do this 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 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 slightly below my 5% floor, which isn’t good.
Somewhat more optimistically, the return on sales has averaged 5.2% over the last five years, but even that is barely above my minimum standard.
The company’s return on capital employed is similarly marginal.
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 the total average capital employed was £7.6 billion, and that capital produced average net profits of £766m, which is 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 retained earnings which are invested directly (organically) into property, plant and equipment.
That makes it harder to measure the strength of the company’s competitive advantages, because companies with strong competitive advantages can typically earn higher rates of return on organic investments.
That’s why it can be a good idea to look at net returns on tangible capital as well as net returns on capital.
In this case, if we adjust capital employed to remove the £10 billion of intangible assets and add back in the pension deficit (kindly assuming that it doesn’t exist) then BAE has produced an average net return on tangible capital employed of 53%, which is very good.
This suggests the company has some strong competitive advantages.
However, the fact that BAE has grown to a large extent through acquisition suggests that there are few opportunities for significant organic (i.e. internally generated) growth.
So while the company may in theory be able generate high returns by investing retained earnings into new tangible assets, in reality the company may have to acquire its way to growth.
And if that’s true, future returns on capital will be determined as much by the price paid for acquisitions as it is by returns on organic investment into factories, machinery and so on. In which case, the standard return on capital (about 10% for BAE) is a reasonable estimate of the returns investors can expect on any retained earnings.
In summary then, (1) BAE may have strong competitive advantages but (2) its opportunities for significant organic growth may be limited, so (3) it may be forced to grow primarily by acquisition.
Let’s now turn, at last, to the other complicating factor: the company’s large pension deficit.
Financial obligations are on the high side
Companies with large and relatively inflexible financial obligations can often find themselves in a lot of trouble very quickly. That’s why I have a couple of related rules:
The rules around pension deficit calculations are long and shrouded in mystery, but for a variety of reasons there is almost always a difference between a pension fund’s ‘accounting’ deficit and its ‘actuarial’ deficit.
In BAE’s case, it has a net retirement benefit obligation on its 2018 balance sheet of about £4 billion, while the results of its triennial actuarial valuation show a funding deficit of £2.1 billion.
Let’s be kind and assume £2.1 billion as our working figure. So BAE’s:
- ten-year average net profits come to £766 million per year
- total pension liabilities (the total liability, not just the deficit) are £23.7 billion (yes, that’s almost £24 BILLION)
- net pension deficit is £2.1 billion
- total 2018 borrowings are £4.3 billion
- total borrowings plus money ‘borrowed’ from the pension fund of £6.4 billion
Those figures give the following results:
- Debt Ratio: Borrowings plus pension deficit to 10yr avg earnings = 8.3 (my limit is 5)
- Pension Ratio: Pension liabilities plus borrowings to 10yr avg earnings = 36.5 (my limit is 10)
This does not look good.
By these measures, BAE has a lot of debt (its borrowings alone are almost 6-times its average earnings).
However, its the pension scheme which really puts the nail into the coffin for BAE as a potential investment, as far as I’m concerned.
The company is currently paying some £200 million per year into the pension fund in order to reduce the deficit (the dividend is about £700m/yr). That is expected to continue until at least 2022, and any future dividend increases must be matched by additional payments into the pension fund.
In fact, BAE’s stated first use of cash is to pay down the pension deficit, ahead of organic investment in productive assets, dividend payments to shareholders or acquisitions.
In recent years the company has entered into several insurance deals where longevity risk (i.e. the risk that pensioners live longer than expected) is effectively offloaded to an insurance company. For a fee, of course.
However, these longevity swaps (as they’re known) only cover a few billion out of the total £24 billion liability, so most of the longevity risk still sits with BAE and its shareholders.
I’m not saying BAE shouldn’t pay into the pension scheme because clearly it should. It has a financial obligation to ex-employees and it should honour that obligation. But the pension fund still represents a massive drain on cash and even when (if) the deficit is cleared the gigantic pension fund will still be there, lurking in the background like a ticking timebomb.
These huge financial obligations, layered on top of the company’s low-growth track record, thin dividend cover and thin profit margins, are not exactly the sort of features I look for in a long-term investment.
Nice dividend, shame about everything else
Despite BAE’s initially attractive dividend yield, the company currently sits at position 126 on my stock screen, out of about 185 consistent dividend payers from the FTSE All-Share.
That’s below the halfway point which implies, somewhat simplistically, that BAE is probably priced above its intrinsic value.
Another way to think of this is to say that BAE, with a dividend yield of 4.7%, would have to grow that dividend consistently at 3% or more in order to match the expected returns of the stock market as a whole.
And of course that doesn’t reflect the margin of safety which investors should demand when investing in a single company rather than a broadly diversified index tracker.
To be at least fairly valued, BAE would need to grow its dividend at something more like 5% per year over the long-term. And based on its track record, I don’t think that’s the most likely outcome.
Alternatively, if BAE was available with a yield of say 7%, then income rather than growth would do most of the heavy lifting and the dividend would only need to maintain its current 2% per year growth rate, or thereabouts.
A 7% yield would be achieved at a price of 320p, or 30% below the current share price.
However, even if the shares fell to 320p there would still be significant risks around the company’s enthusiastic use of debt and its enormous pension fund and pension deficit.
So does this mean BAE is guaranteed to be a bad investment over the next few years?
No, of course not. The future is far too uncertain to be that sure.
But it does guarantee that I won’t be investing in BAE anytime soon.