When Will BAE Systems plc And Rolls-Royce Holdings PLC Start Firing On All Cylinders Again?

For years, UK engineering giants BAE Systems (LSE: BA) and Rolls-Royce Holdings (LSE: RR) were kings of the road. Investors thought they would motor on forever, but both have stalled lately. Over the past five years, BAE has grown just 24%. The Rolls-Royce share price is up just 9%. These aren’t exactly car crash figures — over the same period, the FTSE 100 rose a modest 11% – but it isn’t smooth motoring either.

You would have thought BAE Systems would be firing on all fronts, given today’s political uncertainties, but cash-strapped Western countries have treated defence spending as if it was a luxury they could no longer afford. Given China’s aggressive island-building spree in the South China Sea, Vladimir Putin’s manoeuvrings in the Crimea, Ukraine and now Syria, and Middle East chaos spreading into Europe’s neighbour Turkey, defence no longer looks like a luxury. 

Falling Back On Defence

The other problem is that the nature of warfare is changing. All the military hardware in the world couldn’t tame Afghanistan and Iraq, and it probably won’t help Putin save face in Syria, either. Aircraft, tanks, submarines, cruise missiles and nuclear warheads look increasingly obsolete, given that nation states daren’t use them against each other, and struggle to use them effectively against terrorists. If cyber warfare is the future then BAE Systems still has a lot of catching up to do, although it is taking steps in this direction. 

Still, BAE has had success selling kit for the European Typhoon, securing orders for Royal Navy Type 26 frigates, and equipping our delightful ally Saudi Arabia for its adventures in the Yemen. US defence spending is on course to rise next year. It is also doing better in commercial aerospace. Trading at just 12 times earnings and yielding 4.5%, it looks a solid buy for patient investors.

Rolling Backwards

Engineering giant Rolls-Royce is even cheaper than BAE, crashing to just 10.5 times earnings after a torrid six months that saw its share price fall 30%. It has issued four profit warnings since the start of last year, the most recent in July, on day two of new chief executive Warren East’s tenure.

Rolls-Royce is yet another victim of the lower oil price. This has knocked orders at Rolls-Royce’s marine division, which supplies the offshore oil industry, and emerging market demand for jet engines. Defence cuts, a weaker global economy and Russian sanctions have added to the pressure. A scrapped share buyback, regular job cuts and the company’s arrogant attitude to communicating results suggest that East has a tough job on his hands.

Despite the recent share price cash the yield remains disappointing at 3.3%, although handsomely covered 2.8 times it should at least be secure. A forecast drop in earnings per share of 17% this year and 19% in 2016 suggests the turnaround will be slow. But aircraft orders remain strong, its TotalCare aftermarket division powers on, and with some of the premium taken out of the share price, now may be the ideal time to book your seat before Rolls-Royce hits the road again.

Before rushing to buy either stock you might want to look at this exciting prospect, which the Motley Fool's Head of UK Investing has singled out as his 1 'under-the-radar' pharmaceutical stock with blockbuster potential.

This company has already delivered a strong return and our top expert believes there could be more to come. In fact, he reckons it offers investors potential upside which may be as high as 45%!

To find out which stock we consider one of the best small caps in the country, simply download our brand-new wealth report. It is free and without obligation, so click here now.

Harvey Jones 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.