Are dividends doomed at these two companies?

Roadside recovery firm AA(LSE: AA) released its half-year results this morning. There was plenty for investors to be encouraged by, but I see dark cloud that could spell trouble for the dividend.

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Accelerating momentum

The good news is that halfway through management's three-year transformation programme, member numbers have started to rise, reversing a long-term historic decline.

The company's investment in marketing and digital innovation is bearing fruit, and executive chairman Bob Mackenzie said: "We are increasingly confident about the scale of the opportunity for the brand across the group's many products and services from breakdown cover to mortgages."

Debt remains high, even after last year's £199m equity raise and this year's £130m proceeds from the sale of AA Ireland. Current net debt of £2.7bn dwarfs the FTSE 250 firm's market capitalisation of £1.7bn and represents leverage of 6.7 times EBITDA, which is high by any standards.

However, AA has very low working capital requirements, low levels of maintenance capital expenditure and is a prolific generator of cash. As capex normalises with the completion of the transformation, the company expects to use its increasing free cash flows to accelerate deleveraging and pursue its progressive dividend policy. Indeed, the board today announced a 2.9% increase in the interim dividend, reflecting the good progress already made by the transformation.

Dividend outlook

The dark cloud for the dividend I referred to earlier is a huge increase in AA's pension deficit. This has more than doubled over the last six months from £296m to £622m as a result of the fall in corporate bond yields following the Brexit vote and the Bank of England's base rate cut.

The company said today: "In light of the anticipated increase in cost of the AA pension scheme, we are undertaking a review of the options for mitigating current and future liabilities."

Six months ago, analysts had been expecting AA's dividend growth to accelerate into mid-teens from next year. However, forecasts have come down dramatically since the EU referendum, and today's news on the size of the company's pension deficit, combined with its high level of borrowings, could further reduce dividend growth prospects.

AA's running yield is 3.2%. There are plenty of companies around with a similar or higher yield, but with lower debt and less onerous pension obligations, which appear better equipped to increase their dividends at a faster rate.

A £6.1bn hole

BAE Systems(LSE: BA) is another company where a ballooning pension deficit could put a damper on dividend growth. The £16.6bn FTSE 100 firm saw its deficit swell from £4.5bn to £6.1bn over the first six months of this year, with net debt also rising from £1.4bn to £2bn.

BAE's debt level compared with its market capitalisation is considerably less extreme than that of AA. The aerospace firm's net debt/EBITDA leverage is also relatively modest. Nevertheless, the funding shortfall of the pension scheme is substantial and a greater proportion of cash than previously is likely to flow in that direction than into shareholders' pockets.

BAE's annual dividend growth has slowed to sub-2% in the last couple of years and there appears little prospect of this improving while the pension scheme remains so deep in the red. BAE's running yield of 4% isn't unattractive but, again, there are companies with a similar yield and much stronger dividend growth prospects.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.