Many investors include aerospace and defense (A&D) companies or exchange-traded funds (ETFs) in their long-term portfolios.
Today, we look at a global name in the sector, namely FTSE 100 member aero-engine manufacturer Rolls-Royce (LON:RR) (OTC:RYCEY).
Over the past year, RR stock is down more than 50%. On Jan. 14, it closed at 106.65p ($1.53 for U.S.-based shares).
Rolls-Royce's history goes back to 1906. Car enthusiasts will know the quintessentially British luxury car. But During World War I the company also become an aero-engine manufacturer. Financial difficulties in the 1970s led to it separating into two entities, cars and aero-engines.
In 1998, Rolls-Royce Motors, the car group, was sold to Bayerische Motoren Werke (DE:BMWG) (OTC:BMWYY), the Germany-based automaker known as BMW. The second entity, Rolls-Royce Holdings PLC, which has continued making aero engines, is the company we are looking at today.
Governments Are Biggest A&D Customers
Aerospace includes military and commercial aircraft. Due to the pandemic, the civilian segment of aerospace businesses took a significant hit in 2020. The number of flying hours in civil aviation has dropped sharply, affecting not only airlines, but also companies like Rolls-Royce and Boeing (NYSE:BA). As a result, revenues and earnings over the past year have been mixed at best.
On the other hand, most countries typically have no shortage of defense budgets, helping many A&D businesses generate ample revenue.
In 2019, the U.S. had the highest military spending, followed by China, India, Russia and Saudi Arabia.
When we look at military expenditure as percentage of gross domestic product (GDP), the list changes somewhat. In 2019, Saudi Arabia led this list, followed by Israel, Russia, the U.S. and South Korea.
Recent metrics also highlight:
"Europe's defense market is growing, with budgets increasing steadily over the last five years. The continent makes up 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 aero-engines are found not just in civil and military airplanes but also in other industries. For instance, 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 engineering services as well as products and safety-critical systems for nuclear power stations.
Half-year results in August 2020 showed the adverse effect of the pandemic on operations and metrics. Reported revenue was £5.8 billion (or $7.9 billion), down 26% year-on-year (YoY). Reported loss before tax came in at £5.4 billion (or $7.4 billion).
In December, Rolls-Royce released a trading update. Management’s focus has been 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) of free cash flow in 2022. However, if the recovery in aviation following the pandemic takes longer than expected, this expectation may not fully materialize.
CEO Warren East said:
"We have made rapid progress on our restructuring program and the consolidation and reorganization of our civil aerospace footprint is well under way. 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 of delivering more sustainable power to support the creation of a net-zero carbon economy.”
Despite the decline in the stock price in 2020, RR shares started January on better footing. The company announced it "signed an innovative contract with the UK Space Agency for a study into future nuclear power options for space exploration."
NASA has also been looking at nuclear energy for space travel as nuclear fuel could decrease travel times significantly.
The new decade could see Rolls-Royce widen its product and service offerings and increase revenue.
Bottom Line
Rolls-Royce is an important member of the FTSE 100 index and a globally-recognized name in A&D. However, it may be several quarters before the company starts creating significant shareholder value.
Given the reality that most commercial flights globally are still on hold, Rolls-Royce may not be immune to further turbulence in the air. We’d look to buy RR stock if there is a decline of about 5%-7% from the current levels. We’d also like to see the next half-year results, expected in the coming weeks, to see how the company is continuing to strengthen its balance sheet.
Investors who are looking for investment opportunities in the industry could also consider several ETFs. They include the Invesco Aerospace & Defense ETF (NYSE:PPA), the iShares U.S. Aerospace & Defense ETF (NYSE:ITA), the SPDR® S&P Aerospace & Defense ETF (NYSE:XAR) and the Procure Space ETF (NYSE:UFO).