Can Rolls-Royce Holdings PLC Catch Up With BAE Systems plc?

Rolls-Royce Holdings PLC (LON: RR) has slipped behind BAE Systems plc (LON: BA). Can it bounce back with FY results?

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The aerospace industry was squeezed by the recession, but BAE Systems (LSE: BA)(NASDAQOTH: BAESY.US) managed to pretty much shrug it off thanks to its big overseas sales, principally to Saudi Arabia. Earnings have been up and down a bit, mainly due to the nature of payments for multi-year projects, but they’ve been steady.

Rolls-Royce Holdings (LSE: RR)(NASDAQOTH: RYCEY.US), on the other hand, shocked the world with a couple of profits warnings in 2014, telling us it doesn’t expect to see earnings returning to growth until at least 2016. That did give the markets a bit of a fright, and the share price is down 24% over the past 12 months to 913p — compared to a 19% rise to 521p for BAE.

Earnings set to fall

We have full-year results from Rolls due on Friday 13th, so will they provide the kickstart needed to get the company back to its former reliable health?

We’ve had some cost-cutting and the offloading of some business, and an interim update in November told us that restructuring charges are likely to knock around £60m per year off  underlying profit in 2014 and 2015. October’s guidance was reiterated, and that suggested a 3.5% to 4% fall in 2014 revenue compared to 2013. Free cash flow should also drop significantly, from 2013’s figure of £780m to around £350m.

With the detailed level of guidance given by Rolls, there are unlikely to be any surprises when we get the results on Friday. Analysts are currently predicting a 4% fall in EPS followed by something similar in 2015, giving us P/E ratings of 14.3 and 14.8 respectively.

So are we looking at a bargain situation after the share price fall?

A change in sentiment

Well, Rolls Royce shares have commanded higher P/E ratings than BAE in past years, and that’s come largely from the generally strong sentiment surrounding what has been seen as a superior company that doesn’t see sales falling and just does not issue profit warnings. But that myth has been shattered now, and we may well be looking at a long-term rerating of the two companies’ relative valuations.

BAE shares are on a lower forward P/E multiple, of around 13. And, crucially, BAE is offering superior dividends — there’s a yield of 3.9% expected for 2014 rising to 4.1% in 2015, compared to just 2.5% and 2.6% from Rolls for the same two years. Granted, Rolls’ dividend should be better covered, but the company has been paying lower-than-average yields for some years now with the shares on higher-than-average valuations.

Which is better?

It looks like Rolls-Royce still has a couple of years of work ahead of it to get back on track for earnings growth, and even after the stronger share price performance I still think BAE is looking better value.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alan Oscroft 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.

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