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Several weeks ago, BAE Systems (OTCPK:BAESF) (OTCPK:BAESY) announced that it is in discussions regarding a potential 'merger' with the European civilian aircraft and weapons manufacturer, EADS N.V. (OTCPK:EADSF) (OTCPK:EADSY).

A lot has been written since about the economic and political implications if and when the two groups come together. However, what has been lacking is some proper analysis whether a transaction is in the interest of dividend income investors in BAE Systems.

The timely release of our Financial Strength Database several weeks ago, has confirmed our belief that several of BAE Systems' core financial metrics are flagging that all is not well with the company.

For instance, the company's historic free cash flow payout ratio (rather than the more widely used earnings based payout ratio) is very high, which indicates that not only the dividend is at risk, but the ability to grow its dividend from free cash flow appears to be poor.

To ascertain the sustainability of the ability for dividend paying companies to keep paying their dividend we have developed our proprietary DividendStrength Score, which compares the company's Financial Strength, dividend History, and our proprietary Price Dividend Growth (PDG) ratio. The higher the Dividend Score, the less likely the company is to cut its dividend or default on its obligations.

Unfortunately, BAE Systems has one of the worst DividendStrength scores of the companies we are covering.

The EADS deal

BAE Systems and EADS currently have very different dividend policies. BAE Systems has been paying a higher proportion of its earnings in dividends. According to the deal 'terms,' BAE Systems and EADS' normal dividend payments in respect of 2012 would be unaffected. In 2013, assuming that the combined earnings are broadly in line with current expectations, it is envisaged that the combined group would declare dividends such that BAE Systems shareholders would receive an equivalent amount to that declared in respect of 2012.

The dividend policy for 2014 and beyond would be a matter for the board of the combined group. A balance between the two groups might be used, with BAE shareholders seeing a lower pay out compared to earnings and EADS shareholders a higher one.

The relevance to us, as long term dividend income and dividend growth investors in BAE Systems, is that the dividend of the new combination, as far as those shareholders who previously held BAE Systems shares are concerned, will be frozen for 2013 compared with 2012.

Just this fact alone should put dividend income investors holding BAE Systems shares on strong amber alert as we require regular dividend growth, or at least the prospect of sufficient, preferably above inflation, growth in dividends for any shareholding to remain part of a dividend income portfolio.

Currently BAE Systems forecast a modest rise in dividends for 2013, from the 19.5 pence expected to be paid for calendar year 2012 to 20.2 pence anticipated for 2013. A rather pedestrian projected increase of 3.6 percent, equaling projected inflation for 2013.

As a dividend income investor one may 'tolerate' just an inflation rate increase of dividends for one year, but this should not become a habit. Therefore, dividend income investors require a strong statement on future dividends. Some strong wording about a progressive dividend policy rather than the proposed dividend policy for BAE - EADS for 2014 and beyond, which, as it states, are expected to "balance the importance of dividends against the group's future investment needs".

2014 is less than 15 months away. Taking into account the rather static dividend proposed for 2013, and the woolly statement about future dividend 'policy' I would expect a further freeze or even a dividend cut for 2014.

Also, even, taking into account the perceived balance sheet strength of EADS - EADS has a significant cash balance of €11 billion which (presumably) will be shared (60/40%?) with BAE Systems - my suspicion about the future sustainability of the new combination's dividend is further strengthened by the fact that EADS has a rather haphazard dividend track record. And do not forget, its current dividend yield remains well below that of BAE Systems even after its recent drop in share price. So much so that, EADS shareholders will receive a £200m special payout prior to completion of the merger.

In Conclusion

There are a large, some say insurmountable, number of hurdles to be overcome before the deal can proceed. Because of the national importance and sensitive and often secretive nature of this industry, several governments hold shares in the two companies so they are all involved before any merger is permitted. Also, there may be difficulties with certain very important customers like, for example, the USA Government. Consequently there are some well-founded doubts whether the deal will ever succeed.

Taking note of all the above, we have decided to sell our shareholding in BAE Systems, if and when its share price hits a certain level.

Source: BAE Systems - Deal With EADS Puts Dividend Under Threat