Sector Screener: more potential for Rolls-Royce and BAE shares?

The Aerospace & Defence sector has easily outperformed the wider stock market this year. It is up by 36% year-to-date, while the FTSE 350 index has managed only a 6.9% return.

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There are several reasons for the sector’s sizeable index outperformance. Notably, it has been buoyed by continued elevated geopolitical risks that have prompted an improved outlook for defence firms. Conflict in Ukraine, for example, is showing little sign of abating. And given the presence of ongoing instability in the Middle East, it would be unsurprising if the current trend towards higher military spending among NATO members continues.

Indeed, 23 of the 32 NATO members are expected to meet a longstanding target to spend 2% of their GDP on defence this year. This is significantly higher than two years ago when just seven members met the target and highlights a material and ongoing shift in attitudes towards military spending.

Given that Donald Trump encouraged NATO members to increase their defence spending during his 2017-21 term as president, it would be unsurprising for there to be a similar push from the new US administration over the coming years.

Economic outlook

Since military spending is expressed as a percentage of GDP, an improving economic outlook could also bolster defence spending. This could act as a further positive catalyst on the Aerospace & Defence sector’s performance.

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Although GDP growth in the UK was sharply lower in the third quarter, with the economy expanding by just 0.1% after growing by 0.5% in the previous quarter, US economic growth remained robust at 2.8% on an annualised basis. In the eurozone, meanwhile, GDP growth was four times that of the UK in the third quarter of the year.

Furthermore, the International Monetary Fund (IMF) currently forecasts that the US economy will expand by 2.2% next year, with the UK and eurozone economies expected to grow by 1.5% and 1.2%, respectively. And with interest rates in all three geographic areas having already fallen by 50-75 basis points since June this year, and being widely expected to further decline over the medium term, it would be unsurprising for global economic growth to improve once time lags have passed.

Source ShareScope. Data as at 11 December 2024. Past performance is not a guide to future performance.

Source ShareScope. Data as at 11 December 2024. Past performance is not a guide to future performance.

Passenger growth

An upbeat economic outlook is also likely to be beneficial for the civil aerospace segment, thereby providing a further boost for the broader Aerospace & Defence sector.

After a prolonged cost-of-living crisis across developed economies, inflation has consistently fallen over recent months so that it is now within touching distance of central bank targets. This equates to less financial pressure on consumers, with real wage growth in the UK, for example, now having been positive since April last year. When combined with falling interest rates that have the potential to boost the economy’s performance and the prospects for wage growth, the end result could be greater purchasing power.

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In turn, this is likely to mean higher demand for discretionary items, notably holidays, that equates to greater use of air travel. According to the International Air Transport Association (IATA), global passenger numbers are set to rise by 8% in 2025, followed by growth of 6.1% and 4.7% in 2026 and 2027, respectively. A growing number of passengers and flights should have a positive impact on civil aircraft engine demand and associated maintenance, thereby acting as a positive catalyst on the Aerospace & Defence sector.

Fundamental strength

Of course, the sector’s strong performance vis-à-vis the wider stock market this year means that many of its incumbents are now likely to trade on elevated valuations. While this could mean there is less scope for further capital gains, in some cases their premium valuations may be justified given a continued upbeat outlook for the wider sector.

Indeed, Aerospace & Defence firms that have a solid financial position, a clear competitive advantage and a sound growth strategy could offer index-beating long term return potential. Although their share prices may continue to be volatile as known unknowns such as geopolitical risks and monetary policy changes play out over the coming months, their risk/reward ratios appear to be relatively attractive in some cases.

Source ShareScope. Data as at 11 December 2024. Past performance is not a guide to future performance.

Rolls-Royce

Rolls-Royce Holdings (LSE:RR.)' financial standing continues to improve. Its net debt amounted to £822 million at the time of its latest half-year results. This was down on a figure of nearly £2 billion six months prior and is just a quarter of its level from the end of 2022. When coupled with net interest cover that was in excess of seven in the first half of the year, this suggests it is in a relatively strong position to overcome potential industry-related challenges.

Since the company was initially discussed in this column during March this year, its share price has risen by just under 50%. This compares with a 15% gain for the wider FTSE 350 Aerospace & Defence sector over the same period. As a result, its shares now trade on a forward price/earnings (PE) ratio of around 31. This is clearly exceptionally high, although the firm’s strong growth prospects suggest it could offer a favourable risk/reward opportunity.

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Indeed, Rolls-Royce’s latest trading update showed that it is on track to meet full-year financial guidance. It expects to deliver operating profits of around £2.2 billion, which would represent a 38% growth rate versus the prior year. It is well placed to deliver further profit growth in the coming years, with it reporting in its trading update that demand in its civil aerospace and defence segments remained strong. It also has growth potential in other areas, such as small modular reactors, that could allow it to benefit from wider global trends.

Clearly, difficulties in the aerospace industry supply chain may remain in place over the near term. This could prompt elevated share price volatility over the coming months. But with an improving financial position, upbeat growth prospects and a buoyant operating outlook, the stock appears to represent a favourable long-term risk/reward opportunity.

BAE Systems

The share price performance of fellow Aerospace & Defence sector member BAE Systems (LSE:BA.), meanwhile, has been far less impressive than that of Rolls-Royce since it was first discussed in this column in March. The FTSE 100 company’s market valuation has declined by around 7%, thereby underperforming the wider sector by 22 percentage points.

BAE, though, remains fundamentally sound. Its latest half-year results showed that even after making several acquisitions it has a net debt-to-equity ratio of around 70%. And with its operating profits covering net interest payments nearly 10 times in the first half of the year, it appears to be in a solid position to further invest for long-term growth.

The firm’s latest trading update showed that it remains on track to meet financial guidance for the full year. It expects to produce operating profit growth of 12-14%, with its earnings per share forecast to rise by 7-9%. This suggests that while it trades on a relatively high valuation, with its PE ratio currently at 17, it appears to offer fair value for money given its future prospects and solid fundamentals.

Clearly, the geopolitical outlook is highly fluid at present and subject to change over a short time period. This could mean that BAE’s market valuation experiences heightened volatility over the coming months. But with a sound balance sheet and encouraging recent updates, it appears to offer scope for an improved share price performance over the long run.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.