Can Rolls-Royce Holding PLC’s 2016 Beat QinetiQ Group plc’s 2015?

The aerospace, engineering and defence businesses have had a troubled few years, but the effects on different companies in the same industry have been profound.

If we want to see polarised fortunes, all we need to do is look at Rolls-Royce (LSE: RR) and QinetiQ (LSE: QQ). In a 2015 in which Rolls-Royce saw its shares drop 35% to 592p after a string of five profit warnings in two years, QinetiQ shareholders have enjoyed a 40% rise to 269p.

The QinetiQ share price got a big boost on 19 November when its first-half report told of rising revenue and profits, and signalled a 5.6% rise in the interim dividend – not a massive cash boost, but firmly ahead of inflation. On the day the price rose more than 10%, but I can’t help seeing a little irrational exuberance there. Underlying rises in profits were really very modest and forecasts for the full year suggest only a 1% rise in EPS (followed by a hardly more impressive 3% the next year). So I wonder if it’s a case of investment cash earmarked for the sector simply going into the company that’s doing best?

Too pricey

The thing is, the year’s price rise for QinetiQ has put the shares on a prospective P/E of more than 17, which is a significantly richer valuation than the long-term FTSE 100 average of around 14 – and that’s for a company paying dividend yields of only 2.2% and in a risky sector in a downturn. QinetiQ just seems overpriced to me.

Rolls-Royce on the other hand… Well, it also looks overpriced but for different reasons. In fact, ace investor Neil Woodford recently cut his holdings in Rolls-Royce after a lacklustre November trading update. It contained headlines like: “Further market headwinds increase uncertainty for 2016“. The company told us to expect profit at the lower end of the guidance range and that its outlook suggests “sharply weaker demand in 2016“.

The firm’s new CEO Warren East has launched a streamlining attack on the company’s management structure and is looking to make significant cost savings in the coming year. But the problem is that we’re still facing very gloomy forecasts for 2015 and 2016 – a 20% fall in EPS this year followed by a further 43% drop next year, lifting Rolls’ P/E as high as 19 with only a 2.7% dividend yield expected.

Having said that, Mr East has ceased offering earnings guidance for the next year or so, saying that the outlook is too uncertain. That casts serious uncertainty on even these pessimistic City forecasts.

There’s a better choice

At a low point in a cyclical recovery we should expect to see higher-than-usual P/E multiples, but at this stage I’m far from convinced that Rolls-Royce will have hit the bottom next year. It’s not just the uncertainties of demand, it’s also fuelled by some obscure pricing and accounting practices and by falling margins in the big aero engines business.

I don’t expect shareholders in either of these companies to have a good 2016, and I certainly wouldn’t buy either right now. No, if I had to make a pick in this sector, my money would be on BAE Systems with its forward P/E ratios of under 13 and predicted dividend yields of more than 4%.

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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.