BAE Systems plc Beats Rolls-Royce Holding PLC and Meggitt plc In The Aerospace & Defence Battle

baeThe aerospace and defence sector is going through a tough patch of late, with recession across the Western world leading to cuts in defence spending in the US, UK and across Europe.

But perhaps surprisingly, share prices have generally been beating the FTSE. In fact, Rolls-Royce (LSE: RR) (NASDAQOTH: RYCEY.US) shares have soared to a gain of 130% over the past five years while the FTSE 100 has struggled to beat 40%. The other FTSE 100 giant in the sector, BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) has actually underperformed the FTSE slightly with a gain of around 32%. The much smaller Meggitt (LSE: MGGT) has put on 125% over the same period to 470p.

Here’s a quick snapshot of the FTSE 100 big three:

 Year to Dec BAE Systems Rolls-Royce Meggitt
EPS growth 2013 +8% +10% +3%
10.4 19.4 14.1
Dividend Yield
4.6% 1.7% 2.4%
Dividend Cover
2.09x 2.98x 2.94x
EPS growth 2014
-11% -2% -13%
11.8 15.9 14.3
Dividend Yield
4.7% 2.2% 2.9%
Dividend Cover
1.83x 2.77x 2.40x
EPS growth 2015 +4% +9% +10%
11.3 14.6 13.1
Dividend Yield
4.8% 2.4% 3.1%
Dividend Cover
1.86x 2.76x 2.45x

* forecast

In these lean times I really can’t help feeling that bigger is better, and although Meggitt’s fundamentals are looking reasonable, I’m going to rule it out largely on those grounds — Meggitt has a market cap of just £3.8bn and only just manages to get into the top index, while BAE is valued at £13.7bn and Rolls-Royce at £19.3bn. Had the top two looked overvalued I might have thought otherwise, but at least one of them isn’t.

rrAero engines

 At first-half time this year, Rolls-Royce reported a fall in underlying revenue of 7% and a dip in underlying pre-tax profit of 20%, together with a 2% drop in the value of its order book to £70.4bn.

But that was expected, and chief executive John Rishton told us that “We expect significant improvement in profit for the second half driven by higher revenue and cost reduction“, going on to say that “The prospects for long-term growth remain outstanding across the group and in particular in civil large engines where our market share of engines on order is over 50%“.

Rolls-Royce is clearly a good long-term bet, and I think it probably does justify its premium valuation relative to the sector right now. But I just don’t see it as the best-value pick at the moment.

My choice

That’s BAE Systems, which is trading on a significantly lower P/E rating while offering a significantly higher dividend yield than Rolls-Royce — though admittedly, with weaker dividend cover.

BAE saw similar falls to Rolls-Royce in the first half, but that was put down mainly to a second-half bias in deliveries of Typhoon aircraft, and chief executive Ian King spoke of the company’s “large order backlog of almost £40bn“. Guidance for the full year was maintained, with a small drop in EPS expected after 2013’s second half benefited from a pricing settlement for the firm’s Salam contract with Saudi Arabia.

So, what I think I’m seeing is undervaluation at BAE compared to a fully-valued situation at Rolls-Royce.

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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.