Strong US Dollar Makes Rolls-Royce Holding plc And BAE Systems plc More Attractive

The US dollar is flying high against most currencies around the globe and has remarkably appreciated against the British pound since early July.

If current trends persist, companies such as Rolls-Royce (LSE: RR) and BAE Systems (LSE: BA) are set to benefit over the short term, although long-term value resides in their investment strategies and productivity. 

Time To Buy Rolls?

Currency swings relate mainly to US dollar and euro revenues recognised by the engine-maker‘s overseas entities, where revenue and profits are translated into sterling at the prevailing spot rate.

As Rolls says, a one cent movement in the average US dollar rate will affect revenues and profits by £15m and £2.5m, respectively; a one cent movement in the average Euro rate will affect revenues and profits by £40m and £4m, respectively.

In the first half of the year, the British pound appreciated fast against the euro, but is now trading in line with the level it record in mid-July. Over the period, the pound has weakened a lot against the US dollar. So, what’s next?

Unless interest rates rise in the UK in 1H15, the British pound will unlikely rise much from its current level against the euro, but it could easily drop by 5% to 10% against the US dollar over the period. 

Opportunity

The shares of Rolls are down 30% this year. The order book, revenues, profits, earnings per share and net cash have all declined year in year, half-year results showed. Things have not improved since. 

In mid-October, guidance for revenue was trimmed, as trading conditions deteriorated and Russian trade sanctions led to a number of issues with regard to the Nuclear & Energy and Power Systems businesses. As a result, the stock of Rolls was hammered back then. 

It’s a good time to add some Rolls exposure to your portfolio. Operationally, Rolls is still a bit troubled, but targeted divestments — which are likely to occur, according to my banking sources — could help it deliver plenty of value. Rolls announced earlier this year it would use proceeds from disposals to fund stock buybacks.

Its projected dividend yield is lower than that of the market. Capital gains could be meaningful, however. The shares trade at 900p, a price in line with the average price target from brokers. 

BAE: A Value Play? 

BAE’s profits were hit by currency movements earlier this year, but that’s almost forgotten. Its stock currently trades at its five-year highs, and a weaker or a more stable British pound may help it continue to rally. BAE is proving resilient in a challenging business cycle, which is characterized by tight defense budgets. 

In the second-half of 2014, market consensus estimates have risen by about 10% and more upside is apparent, although the mean price target from brokers is still below BAE’s stock price.

Its trading multiples point to a value play, and there’s a lot to like in a market-beating-dividend yield, too. Finally, BAE remains a takeover target for EADS and other US rivals, but I wouldn’t buy the stock solely on that basis.