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Why I’d pair this dividend champion with Rolls-Royce Holding plc

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Shares in defence-focused technology firm Ultra Electronics Holdings (LSE: ULE) sit around 12% down today on the release of full-year results reporting a decline in operating profits and the termination of a proposed £170m acquisition of US firm Sparton Corporation.

The deal is off

Ultra Electronics has been working with Sparton in a joint venture supplying the US Navy with sonobuoys (an expendable sonar system). When Sparton put itself up for sale during 2016 the takeover deal was put on the table. Yet after the unfavourable outcome of an antitrust review by the US Department of Justice (DOJ) the two firms mutually terminated the merger process.

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Executive chairman Douglas Caster said he is “disappointed,” but the “ERAPSCO joint venture” will continue between Ultra and Sparton, and he expects Ultra to continue supplying the US Navy “for years to come.”  The DOJ plans to open an antitrust investigation into the ERAPSCO joint venture, but Ultra anticipates “working closely with the US Navy during a transition to independently developing, producing and selling sonobuoys.”

Things are working out differently than anticipated, which means that a net £134m raised in a July 2017 placing to fund the acquisition needs to be returned to shareholders via a share buy-back programme. The directors said this is possible because the company remains “highly cash generative with good balance sheet strength.”

That’s even though today’s figures showed that revenue declined 1.3% compared to 2016 and underlying earnings per share slipped by 13.3%. Douglas Caster said the firm “experienced delays to a number of programmes and contracts relatively late in the year.”

A strong order book

Despite difficult trading, net debt fell by 71% to £75m and order intake was almost 16% higher. The order book stood at a healthy-looking £914m at the beginning of 2018. The directors expect modest financial progress during 2018 and underpinned their optimism by pushing up the total dividend by 3.8%. At today’s 1,330p share price, the forward dividend yield for 2019 stands close to an attractive 4%.

Despite short-term challenges, the directors think the defence market cycle looks set for an upturn, so I think Ultra Electronics is worth your research time right now along with Rolls-Royce Holding (LSE: RR), which also has significant exposure to the defence market.

In January, Rolls-Royce announced plans to simplify its business by carrying out an evaluation of strategic options for its Commercial Marine operation and by reducing its five operating businesses down to three core units based around Civil Aerospace, Defence and Power Systems. Such a move suggests the firm will bear down on costs and improve efficiency, which should help directors squeeze more profits from operations. If that happens at a time when the defence market is growing, we could see the stock making progress from here.

Rolls-Royce endured several years of earnings decline recently, but City analysts following the firm expect earnings to grow around 39% during 2019, which could signal the beginning of an enduring revival in fortunes. At today’s share price around 811p, the forward dividend yield runs close to 1.9%.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended Ultra Electronics. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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