Many investors include aerospace and defense companies (A&D)}} or (ETFs) in their long-term portfolios.
Today we are looking at a global name in the industry, namely FTSE 100 member of aircraft engine manufacturer Rolls-Royce (LON 🙂 (OTC :).
Over the past year, the share of RR has fallen by more than 50%. On January 14, it closed at 106.65p ($ 1.53 for US stocks).
The history of Rolls-Royce dates back to 1906. Car enthusiasts will know the quintessentially British luxury car. But during the First World War, the company also became a manufacturer of aircraft engines. Financial difficulties in the 1970s led to it being split into two entities, automobiles and aircraft engines.
In 1998, Rolls-Royce Motors, the automotive group, was sold to Bayerische Motoren Werke (DE 🙂 (OTC :), the Germany-based car manufacturer known as BMW. The second entity, Rolls-Royce Holdings PLC, which has continued to make aircraft engines, is the company we are looking at today.
Governments Are Largest A&D Customers
Aviation includes military and commercial aircraft. The pandemic hit the civil segment of the aerospace companies hard in 2020. The number of flying hours in civil aviation has fallen sharply, not only for airlines, but also for companies such as Rolls-Royce and Boeing (NYSE: {{238 | BA). As a result, last year's revenues and profits have been mixed at best.
On the other hand, most countries are generally not short of defense budgets, allowing many A&D companies to generate ample revenue.
In 2019, the US had the highest military spending, followed by China, India, Russia and Saudi Arabia.
If we consider military spending as a percentage of gross domestic product (GDP), the list changes somewhat. In 2019, Saudi Arabia topped this list, followed by Israel, Russia, the US and South Korea.
Recent statistics also highlight:
"The European defense market is growing, with budgets steadily increasing over the past five years. The continent represents 16% of global defense spending, with a compound annual growth rate of 3.4% between 2015 and 2019."
With that information, let's see where Rolls-Royce fits in the industry.
Recent Earnings
Rolls-Royce aircraft engines are found not only in civil and military aircraft but also in other industries. For example, its subsidiary in Bergen, Norway, supplies medium-speed engines for power generation applications for the oil, gas and marine industries.
The group also provides specialized technical services as well as products and safety critical systems for nuclear power plants.
Semi-annually in August 2020 demonstrated the negative effect of the pandemic on operations and measurement data. Reported sales were £ 5.8 billion (or $ 7.9 billion), down 26% year-on-year (yoy). The reported pre-tax loss was £ 5.4 billion (or $ 7.4 billion).
In December, Rolls-Royce released a trade update. Management's focus was on achieving cost savings of £ 1 billion (or $ 1.36 billion) for the full year. Nonetheless, the company is likely to end 2020 with "net debt of between £ 1.5 billion and £ 2.0 billion, excluding lease liabilities of approximately £ 2.1 billion."
Management believes it will be able to generate £ 750 million (or $ 1.02 billion) in free cash flow by 2022. However, if the post-pandemic aviation recovery takes longer than expected, this expectation may not fully materialize.
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CEO Warren East said:
" We have made rapid progress with our restructuring program and the consolidation and reorganization of our civil aerospace footprint is well underway. Our £ 5 billion recapitalization package in November was well supported and has increased our resilience and strengthened our balance sheet … [W] e continue to drive our ambition to deliver more renewable energy to support the creation of a carbon-free economy.
Despite the fall in the stock price in 2020, RR stocks started better in January. The company announced that it had "signed an innovative contract with the UK space agency to study future nuclear energy options for space exploration."
NASA has also looked at nuclear power for space travel, as nuclear fuel could significantly reduce travel time.
In the new decade, Rolls-Royce could expand its product and service offering and increase revenues.
Bottom Line
Rolls-Royce is a major member of the index and a globally recognized name in A&D. However, it can take several quarters for the company to start creating significant shareholder value.
Given the reality that most commercial flights worldwide are still on hold, Rolls-Royce may not be immune to further turbulence in the air. We would like to buy RR shares if there is a decline of about 5% -7% from current levels. We would also like to see the next half-year results expected in the coming weeks to see how the company continues to strengthen its balance sheet.
Investors looking for investment opportunities in the industry may also want to consider various ETFs. They include the Invesco Aerospace & Defense ETF (NYSE :), the iShares US Aerospace & Defense ETF (NYSE :), the SPDR® S&P Aerospace & Defense ETF (NYSE 🙂 and the Procure Space ETF (NYSE :).
