Rolls-Royce Holding (LSE: RR) and BAE Systems (LSE: BA) have had a wildly divergent 2015, with Rolls Royce down over 35% and BAE up 4%. Are these two titans of British industry set to continue on their respective paths in the New Year or will their share prices jet higher?
Hit by five profit warnings in two years, and with activist investors coming out of the woodwork to attack management, Rolls Royce has seen its shares plunge by more than a third over the past year. Investors have been stampeding for the exits due to low margins in the company’s bread and butter civil aerospace division, low oil prices denting maritime engine sales and an inefficient corporate culture.
Relatively new CEO Warren East, who successfully led ARM Holdings for a decade, should look to the success of General Electric’s commercial aviation division for the key to future growth. GE Aviation has slashed costs since the financial crisis by moving more of their supply chain in-house. Rolls has begun to go down this path by increasing its stake in several Asian maintenance partners, a necessary step to close the gap on GE’s estimated 5% higher margins.
East has also begun to attack Rolls-Royce’s bloated corporate culture by streamlining decision-making through divisional consolidation, and has promised a further £200m in cuts next year. With a virtual duopoly in the wide-body commercial engine market and a proven path to higher profits, I believe that investors with a long-term perspective have a golden opportunity to buy into Rolls-Royce at a very attractive valuation.
BAE Systems has enjoyed a 10% increase in share price over the past month, as increased defence budgets in its three main markets — the UK, US and Saudi Arabia — have increased after several years of cutbacks. These three countries together account for three-quarters of revenue and provide a natural hedge to lower defence budgets in any one market.
The defence manufacturer has wisely sought to mitigate the effects of the cyclical nature of the industry on revenue by expanding its cyber security and electronic systems divisions. Together, these two now account for 24% of sales and make BAE less reliant on major projects and less vulnerable to swings in defence spending by national governments.
Despite defence budgets in the developed world set to increase over the next few years, and an appealing 4.2% dividend, long-term investors can find better uses for their capital than BAE. The industry remains a highly cylical one reliant on large orders from fickle national governments and holds low potential for runaway growth.
On the other hand, Rolls Royce is in an enviable position as one of only two providers of wide-body engines in a market which is set to increase for decades to come as international air travel continues to expand. With a highly capable CEO, quality products and a plenty of fat to cut, I believe Rolls Royce has the potential to provide very high long-term returns to patient investors.