A Closer Look at BAE Systems' Dividend Potential

LONDON -- Dividend income accounts for around two-thirds of total returns, the actual rate of return taking into account both capital and income appreciation. Given that share prices are often volatile and unpredictable, the potential for plump dividends can give shareholders much-needed peace of mind for decent returns.

I am currently looking at the dividend prospects of BAE Systems  (LSE: BA  ) (NASDAQOTH: BAESY  ) and assessing whether the company is an appetizing pick for income investors.

How does BAE Systems' dividend history stack up?

  2009 2010 2011 2012
FY Dividend Per Share 16p 17.5p 18.8p 19.5p
DPS Growth 10.30% 9.40% 7.40% 3.70%
Dividend Cover 2.5x 2.4x 2.4x 2x

Source: BAE Systems Company Accounts

BAE Systems has punched solid annual dividend growth during the past five years, if the effect of fluctuating earnings has caused expansion to gradually deteriorate. Still, the company has still maintained a progressive dividend policy even as profits have dipped, and last year's dividend growth came despite a 14% earnings per share (EPS) decline.

Even though earnings pressure has caused dividend coverage to erode over the period, shareholder payments have remained around the widely regarded safety benchmark of two times prospective earnings.

What are BAE Systems' dividends expected to do?

  2013 2014
FY Dividend Per Share 20.4p 20.8p
DPS Growth 4.60% 2.00%
Dividend Cover 2.1x 2x
Dividend Yield 5.40% 5.50%

Source: Digital Look

City analysts expect dividend growth to continue over the medium term, albeit firmly in low-to-mid-single-digit territory, although dividend cover still remains around two times earnings. An anticipated 10% EPS rebound this year is expected to underpin this, before earnings flatline again in 2014.

BAE Systems' interims last week revealed that performance during the first five months of 2013 had been "consistent with management expectations", with uncertainty related to sequestration in the U.S. continuing to roll onward. Reduced spend from the firm's largest single customer helped force revenues 7% lower last year £17.8 billion, causing profit before tax to also slip 7% to £7.8 billion.

However, BAE Systems still remains a crucial provider to the U.S. armed forces, and followed up a mammoth $780 million deal in March for explosives provision with an $80 million accord last month to service the Navy's submarines' weapons systems. Additionally, the firm is accelerating activity outside of the U.S. and U.K. to offset revenues issues here -- orders here advanced 133% in 2012 to £11.2 billion -- and reported a further £2.3 billion of orders in January-May from these territories.

How does BAE Systems' dividend prospects rate against the competition?

  Prospective Dividend Yield Prospective P/E Ratio
Aerospace and Defence 2.50% 12.5
FTSE 100 3.20% 15.7

Source: Digital Look

BAE Systems currently changes hands on a P/E rating of 8.9 for 2013, representing a massive discount to both the FTSE 100 as well as its sector peers. BAE Systems also provides a prospective dividend yield substantially higher than both of these groups.

In my opinion, BAE Systems is an excellent pick for income investors. I believe that the firm's key role as a top-tier equipment and services provider to the U.S. military machine, combined with accelerating activity in other international markets, should maintain earnings growth and thus underpin future dividends. Furthermore, I believe the company's £1 billion, three-year share repurchase hammers home its position as a deliverer of solid shareholder returns.

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