The Pros And Cons Of Investing In Rolls-Royce Holdings plc

Stock market selections are never black-and-white decisions, and investors often have to plough through a mountain of conflicting arguments before coming to a sound conclusion.

Today I am looking at Rolls-Royce Holdings (LSE: RR) (NASDAQOTH: RYCEY.US) and assessing whether the positives surrounding the firm’s investment case outweigh the negatives.

US defence agreement eases worries

Rolls-Royce’s position as a top-tier supplier to the US and UK armed forces has helped insulate it against the severe earnings woes besetting much of the defence sector. Indeed, its Defence Aerospace arm saw underlying revenues rise 9% in January-June, to £1.2bn, with a steady stream of contract wins from Western governments pushing its order book here £900m higher during the period.

And news this week of easing pressure on US defence budgets has improved the outlook for revenues growth here even further. A bipartisan budget agreement on Capitol Hill saw the budget for 2014 rise to $520.5bn for next year, up marginally from $518bn in 2013, assuaging fears of extensive cuts to arms spending in the near future.

An expensive sector pick

Even though many of Rolls-Royce’s defence peers witnessed stunning share price rises following developments Stateside — fellow FTSE 100 stalwarts BAE Systems and Cobham added 2.4% and 2.1% respectively — the company still trades at an elevated earnings multiple compared to its peers.

Indeed, for 2013 Rolls-Royce currently boasts a P/E rating of 18.2, although this falls to 16.7 next year based on current earnings projections. Still, these figures represent a meaty premium to a forward average of 14.1 for the complete aerospace and defence sector.

Strength in diversity

However, many believe that Rolls-Royce is deserving of this premium given the extensiveness of its engineering prowess across many red-hot engineering markets, a phenomenon which protects earnings from potential weakness in a handful of sectors.

In particular, the firm’s exposure to the lucrative civil aerospace sector continues to pay rich rewards, and Rolls-Royce saw underlying revenues from this division rise 6% during January-June to £3.2bn. The firm’s stellar reputation as a blue-chip innovator also saw turnover at its Marine and Energy divisions advance 16% and 10% in the first six months of 2013.

Cash under the cosh

But the company’s balance sheet is becoming an increasing source of concern. Indeed, Rolls-Royce recorded a £461m cash outflow during January-June, partly due to a £261m rise in inventory. The firm also saw net cash decline to £921m as of the end of June, a 30% decline from £1.32bn recorded at the same point in 2012.

The defence play has promised to get tougher on expenses, commenting that although “some progress has been made on cost, there is clearly more to do,” although this is expected to take some time to deliver.

A soaring share selection

Still, I believe that Rolls-Royce’s role as a prime innovator across a multitude of engineering sectors makes it an excellent growth stock. The business continues to devote huge sums to keep it at the technological cutting edge, particularly in the hottest growth markets, and it is this expertise which should underpin strong earnings expansion over the long-term.

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> Royston does not own shares in any of the companies mentioned in this article.