BAE Systems (OTCPK:BAESY) (OTCPK:BAESF) is one of the bluest of blue chip stocks you could imagine: It's big, it's defensive and it has a dividend yield of more than 4%. It sounds like the perfect choice for a high-yield portfolio.
That's a fair summary of how I used to view the company, which is why its shares have been part of my personal portfolio and the UKVI model portfolio since 2011.
But times have changed, and these days, I'm less upbeat about BAE's shares.
A relatively defensive company in a defensive industry
As you're probably aware, BAE Systems is Europe's largest defence company and the world's third largest. It's listed in the FTSE 100 and has a market cap of almost £16 billion, so it should satisfy the size demands of even the most ardent large-cap investor.
It's also a relatively defensive company.
It operates in the Aerospace & Defence sector, which is defined as defensive in the Capita Dividend Monitor, and its financial results (shown in the chart below) also suggest that the company is relatively defensive in reality as well as in theory.
BAE pays a progressive dividend, but progress has been slow
Although the company's results are relatively defensive, the chart tells the story of a company, which has effectively flatlined in recent years, although that isn't entirely the company's fault.
Due to the nature of the financial crisis, governments had to cut their defence budgets. As a result BAE's revenues and profits have gone nowhere, although the dividend has continued to progress (albeit very slowly).
Average financial results and an average valuation
In numeric terms, the company's long-term financial results as compared to the FTSE 100 average are:
- 10-Year growth rate = 0.7% (FTSE 100 = 2.0%)
- 10-Year growth quality (i.e. consistency) = 75% (FTSE 100 = 50%)
- 10-Year profitability = 9.2% (FTSE 100 approx. 10%)
I think a fair description of those financial results is "average." BAE has a lower than average growth rate, slightly above average growth quality and slightly below average profitability.
Although I generally prefer to invest in above average companies, I am willing to invest in average or perhaps even slightly below average companies. However, I will only do that if the price is low enough to more than offset the lack of obvious growth potential.
In this case, I'm assuming that BAE's past growth is a good indicator of its future growth potential, which is an overly simple but usually reasonable starting assumption.
To see if BAE's share price represents good value for money, we can look at the company's current valuation ratios. At a price of 498p, BAE's shares have the following stats (compared to the FTSE 100 at 6,204 points):
- PE10 (price to 10-yr avg. earnings) = 14.2 (FTSE 100 = 14.4)
- PD10 (price to 10-yr avg. dividend) = 27.9 (FTSE 100 = 28.8)
- Dividend yield = 4.2% (FTSE 100 = 4.0%)
The results again are very average. Price to long-term earnings is about average, ditto for price to long-term dividends and ditto again for the dividend yield.
Given BAE's average financial performance and average valuation ratios, it should come as no surprise that the company currently sits about halfway down my defensive value stock screen.
That screen covers about 240 stocks and BAE sits in position 125, a long way from the top 50 where I usually prefer to go hunting for new investments.
My target purchase price for BAE is far below today's price
For me to be interested in BAE, its share price would have to drop down to 350p, and preferably much lower than that.
At 350p, BAE's shares would have a 6% dividend yield, along with PE10 and PD10 ratios that were also much better than average.
That 6% yield would also help drive returns up towards a reasonable level (I generally consider 10% per year as a reasonable minimum return) and also act as bait for other investors who might then drive up the share price.
While 350p and a 6% dividend yield might sound unrealistic in such a market-leading and defensive company, I can assure you they're not.
Buy when things are going badly, not when they are going well
When I invested in BAE back in 2011, the purchase price was 308p and the dividend yield was 5.7%. However, the company's growth rate was over 5% back then and a 5.7% yield from a company with a track record of 5% growth was a very compelling opportunity.
All it takes is a little short-term, fixable problem and a company's share price can fall to extremely attractive levels.
In 2011, the problem was too much US government debt, which led to fixed and arbitrary cuts in spending, including defence. The US government is a huge customer for BAE and so the market rightly assumed that BAE would find it very difficult to get new US contracts signed off.
However, that situation was unlikely to last forever, and it didn't.
The US didn't cut as much as many thought and most of the cuts have been reduced more recently. BAE rode out the crisis and is still going strong, although at a somewhat pedestrian pace.
So I don't think 350p is an outlandish target price by any stretch of the imagination.
Pension liabilities loom large
There is, however, one more fly in the ointment, other than the company's not particularly attractive share price. That fly is its enormous defined benefit pension scheme.
Much like Rolls-Royce (OTCPK:RYCEY), which I reviewed and announced as uninvestable (at least for me) last month, BAE has pension liabilities, which are a significant potential threat to its future prospects.
Over the past five years, BAE has earned an average normalised post-tax profit of just over £1 billion, while its pension liabilities stand at just under £30 billion.
As a result, a pension deficit of just 10% (a fairly typical amount for schemes that are in deficit) would leave the company with a £3 billion hole to fill, from profits of just £1 billion per year.
In reality, the situation is even worse than that as the pension deficit currently stands at more than £4 billion.
Interest on the deficit alone comes to more than £200 million. On top of that, the company feeds around £300 million into the scheme each year to try to reduce that deficit, but £300 million against a £4 billion deficit is like bailing out the titanic with a teaspoon.
So although I wouldn't invest today because I don't find the price particularly compelling, the main reason I wouldn't invest is the company's massive pension liability.
As I mentioned at the beginning, I am currently a shareholder, but my purchase of BAE's shares in 2011 predated my wariness of large pensions.
One option would be for me to sell the shares immediately because I now realise that the pension scheme is a major threat. However, rather than make a snap decision, I am instead factoring the pension into my decision.
In other words, although I'm still holding for now, that large pension scheme makes it more likely that I'll lock in my profits on BAE sooner rather than later.
After that, I'll reinvest the proceeds into something that looks safer and/or significantly cheaper, but exactly when that will happen I do not know.
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