Rolls-Royce: The Power Share

Published in Investing on 23 October 2012

It's not just in aerospace…

A spate of contract wins at Rolls-Royce (LSE: RR) is a reminder to investors that it is not just engaged in aerospace. Within the space of the last few days, the company -- which likes to describe itself as a provider of power systems and services -- has announced three new deals in diverse segments across the world.

Perhaps the most significant is the contract to power the US Navy's future hovercraft fleet, which will transfer men and materiel from ship to shore. It also won an order to power offshore supply vessels to Brazil's oil and gas industry, and has been appointed to supply safety instrumentation to modernise plant at China Guangdong Nuclear Power Corporation.

In truth, civil and defence aerospace together make up about 70% of Rolls-Royce's business. The civil side alone accounts for over half of turnover, though somewhat less of total profits. The marine business is about 20%, and the energy business chips in most of the remaining turnover though it is currently loss-making.

Long term

But Rolls-Royce is a business that has grown by taking a long-term view towards R&D, developing new technology and new applications for its technology. The non-aerospace business represents investment in the future.

It's an approach that has paid off handsomely. The company boasts a customer base of more than 500 airlines, 160 armed forces and 4,000 marine customers. Over half its £11bn turnover represents the provision of after-sales service that provides an ongoing income stream, and the order book covers more than five years' worth of turnover.

The strategy is in marked contrast to the other major FTSE 100 (UKX) defence contractor, BAE Systems (LSE: BA). A group of its investors, led by its largest shareholder Invesco Perpetual, has just written to the board seeking the resignation of the chairman following the company's failed plan to merge with Airbus manufacturer EADS.

Those shareholders fear BAE has no coherent strategy, and has simply pursued growth through a series of acquisitions. Indeed, it has spent a net £14bn on M&A since 1995. The company bought and sold carmaker Rover, and in 2006 it sold its 20% stake in Airbus only to contemplate re-entry into that business with the EADS merger.

Despite recent efforts to develop new geographic markets and diversify into areas such as cyber-security, its strategy has made it highly dependent on US and UK government defence procurement, both of which are under severe financial constraints.

End result

The end result is that since 1989, Rolls-Royce's total shareholder return has been twice that of BAE's.

That's a telling statistic. Rolls-Royce's quality is reflected in its share price: it trades on a much higher price-to-earnings (P/E) ratio and lower yield than BAE.

 Historic P/EHistoric yieldProspective P/EProspective yield
Rolls Royce19.72.0%15.22.3%

BAE is much the cheaper stock and, in the short term, might be the better buy. But if Rolls-Royce repeats its outperformance over the long-term then it would produce better returns for investors, delivered through its share price rather than dividends.

Note how Rolls-Royce's prospective P/E is considerably lower than the figure based on historic earnings, indicating the market expectation that its earnings will grow faster than BAE's.

The two companies neatly characterise two different investment styles. High-yield investors -- such as Invesco Perpetual's Neil Woodford -- see value in BAE. Investors seeking growth might prefer Rolls-Royce.

Despite their different characteristics both companies have much going for them, and could well justify a place in investors' portfolios. If you want to learn more about building a portfolio, I recommend you read the Motley Fool's guide: "10 Steps To Making A Million In The Market". It's free, and you can download it to your inbox by clicking here.

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> Tony owns shares in BAE Systems but does not own any other shares mentioned in this article.

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ScottishPound 24 Oct 2012 , 1:54pm

RR has just signed a $2.6bn deal to supply aero-engines to Singapore Airlines.

theredflag 24 Oct 2012 , 5:59pm

Great company. Too expensive at present IMO, would need to keep growing profits at an unrealistic rate to warrant the current valuation. Sold out of my holding a couple of months ago (had been a great investment). Would certainly buy in in future if/when valuation changes.

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