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BAE Systems plc And Rolls-Royce Holding PLC: UK Aerospace and Defence Sector Going Cheap

BAE Systems

The UK aerospace and defence industry is on sale after shares in the two big beasts of the sector, BAE Systems (LSE: BA) (NASDAQOTH: BAESY) and Rolls-Royce (LSE: RR) (NASDAQOTH: RYCEY.US), were knocked back when the companies announced full-year results.

BAE shares lost 9% and Rolls-Royce was down 14% after both companies said they were suffering from defence cut-backs — though the story in each case is rather more nuanced. Are these temporary set-backs that provide a buying opportunity for long-term investors?

Cuts

BAE wrote off over £800m of the value attributed to its US businesses as it warned that budget cuts would reduce future earnings. Congress’s plans to reduce defence spending by $450bn means BAE’s US business will shrink by about 15% in the next two years.

That downbeat outlook came on top of Germany cancelling a €3.5bn order for 37 Typhoon jets. The Typhoon has lost out to competitors in Brazil, India and the Middle East. And perhaps I’m not alone in suspecting that BAE’s long-awaited price escalation settlement with Saudi Arabia was a tough one. BAE’s results would have been all the worse if the deal had not been signed just the day before — a fact I’m sure wasn’t lost on the Arabs.

Still, BAE is entrenched in US and UK defence procurement with an order book two years long. The Pentagon remains committed to the next-generation F-35 joint strike fighter where BAE has a 17% share. Forecast worldwide sales of 3,000 dwarf the number of Typhoon sales losses. Meanwhile, BAE has upped its dividend 3%.

Booming

Rolls-Royce blamed defence cut-backs when it warned that this year would be the first in a decade in which sales and earnings would see no growth. The aero-engine company gets over 40% of its sales from civil aviation, which is booming.

The share price fall looks an over-reaction, especially as the company expects growth to pick up in 2015. But investors had become accustomed to growth and have been unsettled by allegations of bribery. Some analysts were concerned by changes to the accounting policies required by the Financial Reporting Council, fearing that the FRC might query the company’s capitalisation of R&D costs and accounting for long-term contracts. Rolls-Royce often sells engines for little profit, but with lucrative long-term servicing and spares contracts.

Buying opportunity

Accounting treatment of long-term contracts can have a big impact on reported earnings and valuation, but I’m reassured by Rolls-Royce’s substantial operating and free cash flow. So for me this was a buying opportunity for a quality stock previously missing from my portfolio.

Rolls-Royce's 2.4% yield is half of BAE's, but after holding them for a few years the yield-on-cost of growth companies looks much more appealing. Reinvesting those dividends grows even more value: over the past 25 years, about 60% of the total return from the FTSE All share Index has come from reinvested dividends.

You can learn more about the wealth-boosting power of dividends in 'My Five Golden Rules for Building a Dividend Portfolio'.  It's an exclusive report published by the Motley Fool. You can get it by clicking here -- it's free.

 > Tony owns shares in BAE and Rolls-Royce.