Investor sentiment towards these businesses has soured in 2020 due to their exposure to the airline sector. The coronavirus pandemic effectively shut down the airline industry in March. It could also be many years before it recovers, according to analysts.
This suggests the Rolls-Royce and IAG shares could be set for several years of turbulence. However, both equities are currently trading at some of their lowest levels in recent history. This implies now may be a good time for long-term investors to buy into one of these world-beating operations.
IAG and Rolls-Royce both look attractive from a price perspective. Shares in the two companies are trading at multi-year lows, suggesting they may offer a margin of safety at current levels.
But Rolls-Royce might struggle to return to growth in the medium term. While the company is one of the largest jet engine manufacturers in the world, it’s been struggling for years.
The group’s woes started back in 2017 when problems were discovered in its flagship Trent 1000 engines, which power Boeing’s 787 Dreamliner. These issues forced airlines to ground their planes and Rolls had to fix the problem.
Management believes the total cost of fixing the issue will be £2.4bn by 2023. As well as these severe issues, Rolls has also had to grapple with high costs and a lack of cash flow from the rollout of new engines. Typically, the group sells engines at cost and then makes money on the lifetime service contract.
The pandemic came at a particularly bad time for the group. It was just starting to become cash flow positive, and management was forecasting substantial cash profits in the years ahead.
These predictions are now defunct. It remains to be seen how long it’ll take the group to recover. As such, it could be many years before the Rolls-Royce share price returns to 2019 levels.
IAG shares may be the better buy. Before the pandemic, the airline was already hugely profitable. To cope with the downturn, the firm aggressively cut costs and raised additional funding. These actions should help the group return to profit quickly when demand for air travel begins to pick up.
Indeed, unlike Rolls, which is expected to remain loss-making, the City currently thinks IAG will return to the black in 2021. And if passenger activity returns to 2018/19 levels, investors buying IAG shares today could see substantial total returns.
In these years the organisation made an average net profit of £2.1bn. By comparison, the group’s current market capitalisation is £4.1bn.
These numbers indicate the stock is trading at less than two times normalised income, compared to the long-term average of five. To put it another way, IAG shares may have the potential to increase 250% if activity returns to 2018/19 levels.
Therefore, IAG may be the better buy for discount-hunting investors today.
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Rupert Hargreaves owns no share 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.