Sector Screener: Rolls-Royce and BAE shares still value for money?

Aerospace and Defence is the FTSE 350’s top-performing sector over the past year. It has surged 75% higher, which is over 30 percentage points greater than the second-best performing sector and far superior to the wider index’s measly 3% capital return.

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This vast outperformance may naturally prompt some investors to question whether the sector is now overvalued. After all, the market valuations of aerospace and defence firms are likely to have risen significantly as a result of their buoyant share price performance at a time when a wide range of FTSE 350 stocks offer significant margins of safety.

However, with an increasingly upbeat industry outlook, several sector incumbents continue to offer long-term investment appeal.

Source SharePad. Data as at 13 March 2024. Past performance is not a guide to future performance.

Source SharePad. Data as at 13 March 2024. Past performance is not a guide to future performance.

Growth opportunity following a successful recovery

Civil aerospace companies, for example, are experiencing rising demand for their products and services as air travel continues to recover from the pandemic. Travel restrictions prompted by Covid-19 had a hugely detrimental impact on the sector as they caused a sudden and vast deterioration in passenger numbers that placed significant financial pressure on incumbent firms.

While recovery has proved to be a slow process, the International Air Transport Association (IATA) recently forecast that global passenger numbers will finally surpass 2019 levels in 2024. They are due to increase from 99% of pre-pandemic levels in 2023 to 109% this year and are then set to rise to 119% of 2019 levels in 2025.

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Furthermore, with global passenger traffic expected to double between now and 2040, long-term demand for aeroplanes and the engines that power them, as well ancillary services such as maintenance, is likely to significantly increase.

Certainly, the civil aerospace industry is relatively cyclical. Its growth rate over the coming years is extremely unlikely to be smooth or consistent, since demand for air travel is closely linked to the outlook for consumers and the performance of the wider economy. This could mean that sector incumbents experience relatively high volatility in their financial and share price performance.

While the ongoing presence of rampant price rises and lacklustre economic growth are likely to act as a drag on the sector’s near-term prospects, impending interest rate cuts as inflation moves lower mean that the industry is poised to deliver strong growth over the long run.

Growing demand amid elevated geopolitical risks

Defence stocks also have an upbeat long-term future. The industry’s outlook has been dramatically affected by Russia’s full-scale invasion of Ukraine in 2022. It prompted a vast change in attitudes towards military spending among NATO members. Although they had previously committed to spend at least 2% of GDP on defence, just seven out of 30 members met the target in 2022. This year, 18 out of an increased 32 members are expected to do so as geopolitical risks in Europe, Taiwan and elsewhere remain elevated.

Indeed, defence spending by NATO members increased at an annualised rate of just 2.8% between 2014 and 2022. Following a shift in attitudes, though, military spending is expected to have increased by 7.8% in 2023. Since defence spending among NATO members is closely linked to economic activity levels due to its target being expressed as a proportion of GDP, an improving global economic outlook amid interest rate cuts is likely to act as a positive catalyst on the wider industry.

The US economy, for example, expanded at an annualised rate of 4.9% and 3.2%, respectively, over the past two quarters and, according to the International Monetary Fund (IMF), is due to grow by 2.1% this year. Given that the US has the largest defence budget in the world, its improving outlook is likely to prompt higher demand for a wide range of defence-related products and services. And with the eurozone economy’s growth rate expected to increase from 0.9% this year to 1.7% next year, the prospects for defence stocks are becoming increasingly upbeat.

Rapidly improving financial performance

Source SharePad. Data as at 13 March 2024. Past performance is not a guide to future performance.

Rolls-Royce Holdings (LSE:RR.) and BAE Systems (LSE:BA.) are arguably the two best-known aerospace and defence companies in the FTSE 350. Both stocks have performed extremely well over the past year and yet still offer good value for money.

Rolls-Royce’s share price has been a particularly strong performer of late, rising by 172% over the past year. Investor sentiment towards the civil aerospace and defence company has dramatically strengthened in response to its improving financial performance, with its recently released full-year results showing a 21% increase in sales and a six-fold rise in pre-tax profits versus the prior year.

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Its top line was catalysed by the continued recovery of large engine flying hours in its civil aerospace division. They increased from 65% of 2019 levels in 2022 to 88% of pre-pandemic levels last year, while the company recorded its highest number of large engine orders for over 15 years. Its bottom line benefitted from a doubling in operating profit margins, which rose to 10.3% as cost efficiencies were delivered across its various operations. It expects to further reduce costs as it seeks to generate annualised savings of £400-£500 million over the medium term.

Rolls-Royce’s improving financial performance bolstered its balance sheet. Net debt now stands at £2 billion, versus £3.3 billion in the prior year, with net interest cover amounting to around six on an underlying basis. Its stronger financial position means it has greater capacity to invest in long-term growth opportunities in areas across civil aerospace and defence, as well as in new markets such as small modular reactors that generate electricity.

The company expects to grow operating profits by 16% in the current financial year. With its shares trading on a price/earnings (PE) ratio of around 27, they appear to offer good value for money given the company’s long-term growth potential and improving financial position.

A favourable risk/reward opportunity

BAE’s share price has risen by 42% over the past year. The defence-focused FTSE 100 stock’s latest annual results were highly encouraging, with sales growing by 9% and earnings per share rising by 14% versus the previous year.

The firm experienced growing demand across its broad range of market segments, with order intake of £37.7 billion following several large contract awards during the year leading to a record order backlog of £69.8 billion. It also completed the £4.4 billion acquisition of Ball Aerospace last month, which provides further long-term growth opportunities in areas that are deemed to be high priority in the US defence budget.

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With a net gearing ratio of 23% and net interest cover in excess of 10, BAE has the financial means to conduct further acquisitions to strengthen its competitive position. It also made progress with a £1.5 billion three-year share buyback programme that is due to be completed next year. It will be followed by a further share repurchase programme under the same terms. While its PE ratio has risen substantially to stand at around 19 following its sharp share price rise, the company expects to grow earnings per share at a brisk 6-8% in the current financial year.

Given the long-term growth potential of the defence sector amid heightened geopolitical risks, BAE shares appear to offer good value for money. The company’s solid financial position and diverse range of operations mean it is well placed to capitalise on buoyant market conditions to deliver further capital growth for investors.

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