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Rolls-Royce and BAE Systems are crushing the FTSE 100, but which should you buy?

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It’s been a good year so far for two of the UK’s industrial giants, Rolls-Royce Holding (LSE: RR) and BAE Systems (LSE: BA).

Although the FTSE 100 is trading largely unchanged from January’s opening level, the BAE share price has risen by 12% in 2018.

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And Friday’s surge took Rolls’ shares (briefly) to a new 52-week high of 1,010p. At Friday’s mid-morning price of 960p, the aero engine maker’s shares were trading about 17% higher than they were at the start of the year.

Taking a longer view

This short-term progress is good news for shareholders, but what about the bigger picture? Over the last five years, Rolls has lost about 25% of its value, while BAE has risen by nearly 70%. So the defence giant has been a clear winner.

Despite this, Rolls remain the standout performer over the last 10 years. The Derby-based firm’s stock is worth nearly 170% more than it was in June 2008. This compares very well to a gain of just 54% for BAE, and 33% for the FTSE 100.

The only downside is that Rolls’ dividend has been cut in half since 2015, while BAE’s payout has continued to edge higher. So dividend investors who’ve held Rolls through this period have suffered a big cut in income.

In this article I’m going to take a closer look at the outlook for both firms. I’ll also rate each stock as a buy, sell or hold.

Rolls’ rollercoaster ride

In the years after the financial crisis, booming demand for aero engines and offshore power helped Rolls-Royce became a big-cap growth story. Unfortunately, the firm’s growth credentials have been called into question in recent years.

Chief executive Warren East has been forced to cut the dividend, make changes to accounting policies and handle a Serious Fraud Office investigation. Mr East has also launched a series of restructuring plans in an effort to restore the firm’s profits and free cash flow to historic levels.

The latest of these was announced on Friday and seems aimed at modernising the group’s corporate structure. A total of 4,600 jobs will go, many of which will be from Rolls’ corporate headquarters in Derby.

Cost savings are expected to reach £400m per year by the end of 2020, by which time Mr East expects the group to be generating at least £1bn of free cash flow. His medium-term ambition is for “free cash flow per share to exceed £1.”

Should you buy Rolls today?

Warren East is rated very highly in the City after his time at chip designer ARM Holdings, and I share this view. So I take this new guidance from the company quite seriously.

In 2018, free cash flow is expected to be between £350m and £550m. So to achieve a 2020 figure of £1bn, free cash generation will need to double or even triple over the next two years. That seems realistic enough to me, given that the firm is emerging from a major turnaround.

Valuation questions

This guidance gives us a useful handle on the stock’s current valuation. Broker consensus earnings views give the stock a 2018 forecast P/E of 54, and a 2019 forecast P/E of 32. These figures certainly aren’t cheap, but if Rolls can deliver £1bn of free cash flow in 2020, that would result in a fairly attractive price/free cash flow ratio of 16.

The firm’s medium-term target of £1 free cash flow per share implies a price/free cash flow ratio of less than 10 at today’s price. That’s pretty cheap, but I’m guessing we won’t see that number until the mid-2020s.

This highlights my main problem with Rolls-Royce. Based on the firm’s latest guidance, several years’ growth already seems to be priced into the shares. If I could buy the stock on a current-year P/FCF of 16, I’d be tempted. But since this figure is projected for 2020, I’m less sure.

Today’s forecast dividend yield of 1.5% is a poor reward for patient shareholders. And in my view it could be several more years before Rolls’ shares deserve a price tag of much more than 1,000p. For me, this stock just isn’t cheap enough. I’d rate Rolls-Royce as no better than a hold.

Smooth flying for BAE

While Rolls-Royce has seen a turbulent few years, progress has been fairly serene at defence group BAE Systems.

The group’s electronic warfare and cyber security businesses have made decent progress. And while orders for ships and aircraft tend to be lumpy, the firm signed a £5bn contract to supply 24 Typhoon aircraft to Qatar at the end of last year. Negotiations are also under way for a deal to supply 48 Typhoons to Saudi Arabia, so the future of the aircraft business seems safe for the foreseeable future.

Growth has been limited in recent years, but government defence spending has strengthened in both the UK and the USA. Chief executive Charles Woodburn expects this to continue and says that the group’s US portfolio is “well aligned with customer priorities.”

My verdict on BAE

The defence firm’s shares currently trade on about 15 times last year’s free cash flow. Using this metric, BAE’s valuation today is similar to Rolls-Royce’s forecast valuation for 2020.

BAE also looks much cheaper relative to earnings and dividends. The group’s shares trade on 15 times forecast earnings and offer a prospective yield of 3.4%. Although this is a fairly average yield, it should be covered 1.9 times by earnings this year. So future years could see steady dividend growth.

My investing style focuses on value and income. I’m not comfortable paying a premium for Rolls-Royce stock today in the hope of strong future growth.

In my view, it makes much more sense to buy BAE stock today. It’s reasonably priced and offers a decent dividend yield. The business is already performing well, so we don’t have to rely on the success of a long and costly restructuring programme.

I’d rate BAE Systems as a buy at current levels. 

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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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