10 iconic shares: Rolls Royce

The first of our series of articles using fundamental analysis to examine the prospects of 10 iconic FTSE companies.


Reasons to watch

  1. A long-term history of excellence in the defence and aviation industries
  2. Compelling business prospects in aero engine production
  3. A reasonable valuation that allows for the prospect of a re-rating as performance improves


As names go, they don’t come more British than Rolls-Royce. The company traces its history back to 1906, and over the years it has produced some iconic engines and aircraft. The motor vehicle element was removed during the 1970s, and the firm now concentrates on aircraft engines, with additional divisions involved in marine propulsion and the energy sector.  

The company's Merlin engine, used in the Spitfire and Lancaster aircraft of World War Two, is perhaps its most famous, but its post-war products were used to power aircraft such as the Nimrod and the F4 Phantom, while the new Airbus A380 uses Rolls-Royce engines.

In the years to come, Rolls-Royce will provide the reactor for the new generation of British nuclear submarines, providing a key point of business for the future. It is now the largest producer of aero engines in the world and, as a constituent of the FTSE 100, it is one of the largest listed defence and aerospace firms in the world. 

Fundamental analysis*

Over the past twelve months, Rolls-Royce has seen its shares fall 14%, versus a 1.54% return for the FTSE 100. In the same period, BAE Systems shares are flat while those of rival Meggitt are down 18.4%. For 2014 so far, Rolls-Royce is the clear loser, down 24% versus a FTSE 100 drop of 2%, a drop of 14% for Meggitt and a 7.3% gain for BAE.

In its most recent update, the firm downgraded its assessment for the year ahead, at the same time as reporting an expected drop in first-half revenues and underlying profits. The firm blamed a combination of lower defence spending by major nations, problems caused by a stronger pound and difficult trading at its marine division.

This part of the business is expected to see a fall of 15-25% in profits, along with a one-off charge of £30 million. This is a significant deterioration in the division, which had previously expected a 10% drop including the one-off charge.

Other parts of the business will, for the time being, be able to pick up the slack, through higher revenue and a fall in costs, but the market will be watching out for any sign that the malaise in the marine business is spreading into other areas. Revenue for Rolls-Royce was down 10% to £6.6 billion, while operating profits were hit to the tune of 20%, falling to £644 million.

For the rest of the year, the firm still expects to do well in turbine engines for passenger jets, with 4000 scheduled for delivery in the coming decade, a significant slice of business. In addition, although the pound’s rise over the past year did dent profits, the steady decline in sterling against the US dollar will alleviate these concerns.

On a forward PE of 14.3, Rolls-Royce currently trades at around a 5% premium to its sector mean, with rival Meggitt on 12.7. This compares to a forward PE of 13.8 for the FTSE 100 itself, indicating that Rolls-Royce shares are not at a significant premium either to its sector or the broader market. Defence spending in the developed world is still likely to remain under pressure, so revenues are unlikely to exceed expectations in the months to come. However, the good order backlog should support earnings, given that the first half order backlog is around £70 billion, compared to full-year 2013 revenue of £15.5 billion.

In addition, the airline industry is set for a major overhaul, with over 35,000 aircraft set to enter service in the coming 20 years. As a leading manufacturer of aircraft engines Rolls-Royce is well set to capture some of this market.

The share price trend is not particularly appealing, but if the shares can find support around the £9.50 level and then move back towards £11, then there may be signs of a trend reversal. Any long-term turnaround in the shares would target the all-time highs around £12.50, particularly if Rolls-Royce can show evidence that it is expanding its order book and improving the performance of its maritime division.

*What is fundamental analysis?

Fundamental analysis seeks to examine a security by measuring its value through the use of financial and qualitative factors. Essentially, fundamental investors believe that each share is a piece of a company, and that the company can be analysed to determine whether the current share price indicates whether the company itself is undervalued (trading at a discount) or overvalued (trading at a premium).

The overall objective is to determine the underlying value of a company, and use comparisons with similar companies to determine if the business is likely to be successful or otherwise. Crucially, a company cannot be overvalued or undervalued in isolation. Instead, fundamental analysis compares a company to its peers in the sector, to the broader market, and to past valuations, to determine whether the current valuations are appropriate. 

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