Why I’ve Sold BAE Systems plc To Buy Rolls-Royce Holding PLC

BAE Systems plc (LON: BA) looks expensive but Rolls-Royce Holding PLC (LON: RR) could have a bright future ahead of it.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Over the past two years, the shares of BAE Systems (LSE: BA) and Rolls-Royce (LSE: RR) have moved in opposite directions. 

Indeed, since the beginning of August 2013 BAE’s shares have gained 7.3%, while Rolls’ shares have slumped by 33% following a series of profit warnings, a management shake-up and a lack of corporate direction. 

However, after BAE’s gains and Rolls’ losses, BAE now looks expensive but Rolls appears to be undervalued. 

Hidden value 

Rolls has made many mistakes over the past few years. These errors include a wasteful £1bn stock buyback, diversification into industries where the company has little experience and a slow transition to new product lines.

But now the company is trying to draw a line under these mistakes and move on. Luckily, Rolls has world-leading reputation and multi-billion dollar order book already in place to support this turnaround. 

Specifically, at the end of the first half of this year, Rolls’ order book stood at £76.5bn, equal to more than six years worth of sales at current production rates. 

And with a new management team in place, along with an activist hedge fund — ValueAct, which has a reputation for unlocking value from struggling companies — Rolls’ restructuring should yield lofty returns for investors. 

Warren East, Rolls’ new CEO, has stated that the company’s restructuring plan will be announced sometime over the next 12 months. The programme will be focused on cutting costs, improving cash flows and improving performance at Rolls’ key aero-engines division. 

Long-term contracts 

Rolls’ aero-engines division is where the real value can be found. You see, Rolls shares a duopoly with General Electric in wide-body jet engines, and the barriers to entry for any newcomer would be formidable. In this business, Rolls earns a 20% return on invested capital. However, Rolls’ sales aren’t one-offs: the company sells its engines at cost, or at a loss, but signs lucrative maintenance contracts over the life of the power system. These maintenance contracts produce income for years after the initial sale. There are few other companies with such a lucrative business model. 

Unfortunately, the business benefits of the long-term care business model have been annulled by Rolls’ poor decision to plough cash into its marine engine and power-generation businesses, competitive sectors that are being encroached by low-cost Asian players.

Nevertheless, with an activist on board, and new management in place, it’s likely that Rolls will re-align its business model. This transition should unlock value for investors. 

Struggle to move higher 

Rolls has plenty of room to manoeuvre, restructure and return to growth. However, BAE appears to be fully valued at present. 

For example, BAE’s main peers, the likes of General DynamicsLockheed MartinNorthrop Grumman and Raytheon Co, trade at an average forward P/E of 17.6 compared to BAE’s forward P/E of 17.3. City analysts don’t expect BAE’s earnings to grow this year. 

Moreover, these four leading defines contractors all reported a higher return on shareholders’ equity than BAE during the past year. ROE averaged 40.4% for the group during 2015, compared to BAE’s 39.8%.

The bottom line

So overall, BAE looks to be fully valued at present levels, but with new management in place and a solid base to grow from, Rolls Royce could have a bright future ahead of it. 

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.

Rupert Hargreaves 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.

More on Investing Articles

Investing Articles

Could the Rolls-Royce share price end 2024 above £5?

As the Rolls-Royce share price continues its remarkable run, our writer considers where it might be at the end of…

Read more »

Investing Articles

UK stocks are hitting all-time highs! Yet these 2 still look cheap to me

The FTSE 100's on a roll. But it's still possible to pick bargain UK stocks, provided we know where to…

Read more »

Satellite on planet background
Investing Articles

At just under £14, can BAE Systems’ share price still be a prime FTSE 100 bargain? 

Despite its bullish price run, BAE Systems’ share price still looks undervalued to me and appears set for strong growth.

Read more »

Photo of a man going through financial problems
Investing Articles

2 dividend shares I’d avoid like the plague in today’s stock market

The UK stock market is full of high-yield dividend shares that could equate to a steady stream of passive income.…

Read more »

Abstract bull climbing indicators on stock chart
Investing Articles

£17,000 in savings? Here’s how I’d aim to turn that into a £29,548 annual second income!

Generating a sizeable second income can be life-enhancing and can be done from relatively small investments in high-dividend-paying stocks.

Read more »

Investing Articles

With as little as £300 a month invested, this stock could net £16,000 a year in passive income

Putting a few hundred pounds each month into the stock market could eventually generate a five-figure annual passive income, this…

Read more »

Black woman using loudspeaker to be heard
Investing Articles

This dividend stock could pop next week!

This dividend stock happens to have one of the biggest dividend yields I've come across -- 10.7% -- but I'm…

Read more »

Investing Articles

Up 81%, can this FTSE 100 turnaround share keep surging?

This recovering retailer has been one of the FTSE's greatest performers over the past year. Royston Wild considers whether it…

Read more »