Why I’d Buy BAE Systems plc And Rolls-Royce Holding PLC Despite Falling Profits

Two of the UK’s biggest engineering companies, Rolls-Royce Holding (LSE: RR) and BAE Systems (LSE: BA), published their interim results today.

As I own shares in BAE and have recently added Rolls-Royce to my watch list, I was keen to see whether either company had any surprises in store for investors.

The short version

Shares in Rolls-Royce have fallen by 30% over the last year, thanks to a succession of profit warnings, most recently on 6 July.

Today’s interim results should be a welcome relief for shareholders. Although Rolls’ underlying pre-tax profits fell by 32% to £439m, this was slightly ahead of analysts’ expectations and in-line with Rolls’ latest guidance for 2015.

To sweeten the blow, Rolls also announced a 3% hike in the interim dividend, which will rise to 9.27p.

It was a similar story at BAE. The interim dividend will rise by 2% to 8.4p, despite half-year profit falling to £398m, from £434m during the first half of 2014.

Orders are key

Large industrial firms like Rolls and BAE rely on keeping their order books full in order to plan future production. A shortfall of orders can cause profits to plummet several years in the future.

Rolls appears to be doing better than BAE in this area. Rolls’ order book rose by £2.8bn to £76.5bn during the first half of the year, whereas BAE’s order backlog fell by £3.2bn to £37.3bn during the same period.

Although some lumpiness in new orders is inevitable for firms like BAE and Rolls, it’s worth noting that BAE’s current order book is equivalent in value to just 2.2 years’ revenue, compared to more than five years’ revenue for Rolls.

Given that BAE builds large complex items like fighter planes and warships, this doesn’t seem ideal. The narrative in today’s results seems to back up this conclusion.

BAE warned that its Australian shipbuilding business may have to shut down in the absence of new orders from the Australian government, while there was no news on a hoped-for Typhoon order from the Saudi Arabian air force.

Recent press reports suggest that negotiations are still under way, but BAE will complete its existing Typhoon orders in 2018. The firm does not really have much time to extend the pipeline of orders for this key product.

Valuation reflects risks?

Despite the 30% fall in Rolls’ share price over the last year, Rolls shares still trade on a higher valuation than those of BAE. This is fully justified by today’s results, in my opinion.

BAE’s lack of forward visibility has been a risk for some years and, although defence spending in the UK and US appears to have stabilised, the situation doesn’t seem to be improving.

In contrast, Rolls may be facing short-term headwinds, but its long-term pipeline of aero and marine engine sales looks sound. Roll’s heavy exposure to the fast-growing civil aerospace market looks very attractive compared to BAE’s defence-only positioning.

Today’s best buy?

Although I have concerns about BAE, I believe it remains an attractive long-term income play. Past performance suggests Saudi orders may come through at the last minute.

Rolls also looks attractive. Although the firm faces short-term headwinds, I think its leading position in the aerospace engine market means makes it a good long-term buy at today’s price.