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

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. 

But if you don't believe that Rolls can turn things around, our top analysts here at The Motley Fool have discovered a company that they believe could see its sales increase by 300% to 500% over the next few years

Our analysts believe that the company in question is one of the market's hidden gems. And all is revealed in our new free report

So, if you're interested in finding out more, download our free report today. The report will be delivered to your inbox immediately and there's no further obligation.

This is something you do not want to miss!

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.