BAE shares soar as investor flight from Rolls accelerates

<p>Rolls-Royce shares collapsed on Thursday after it became the biggest UK aerospace and defence firm to warn the outlook remained dark. The second-largest manufacturer of […]</p>

Rolls-Royce shares collapsed on Thursday after it became the biggest UK aerospace and defence firm to warn the outlook remained dark.

The second-largest manufacturer of aeroplane engines in the world gave its fourth profit warning in a year and almost instantly nuked a fifth of its market value.

The lack of a clear way forward to fix persistent weakness in RR’s Civil Aerospace and Marine businesses has increased the risk of a dividend cut.

Sector investors rushed into BAE Systems, which looks further along the changing defence spending curve than its closely-matched rival.



30% off-course

Roll’s board said the payout would be reviewed after sharply weaker demand for spares and engine after-care, as aircraft operators transitioned to fuel-efficient jets.

Rolls had earlier said next year’s profits would miss forecasts by 30%.

Investors are still coming to terms with deepening uncertainty for Rolls-Royce which up to last year had enjoyed 11 years of strong profit and revenue growth.

In July it said profits from its aero-engine business, its biggest income generator, would reverse.

The turn for the worse in the global defence outlook over the last few years, under pressure from dwindling military spending in G7 countries, was compounded by last year’s oil price slide from which there’s been little recovery.

Amid all this, a widely held view is that Rolls could have done with management that was better calibrated to communicating the complexities of its business to investors at a time when this was needed most.

The hope is that recently installed new CEO, Warren East, could stem further shareholder attrition, not least because he’s less likely to take flak for necessary but painful changes.

Principal among these so far, according to East are “fundamental changes” required in RR’s fixed-cost base, which could save between £150m-£200m a year.

The former boss of agile and asset-efficient microchip licensor, ARM, also signalled it was time for certain layers of management to become less comfortable, for the sake of improved execution.

Following another pattern of ‘turnaround’ CEOs, East ramped up a previously estimated profit hit to £650m, from £300m stated in July.



From best to worst

That left the previous average market forecast of pre-tax profit almost 40% higher than guidance, according to Thomson Reuters data.

RR’s cash position was still best-in-UK-class as of the end of its last fiscal year at $1.005bn.

Compare that with a fall to worst-in-class with $51.8m now seen.

It immediately calls into question Roll’s ability to service its dividend yield, which itself had latterly slipped below the blue-chip average.

There’s also a hint in all this that calls from activists for a break-up, including No.2 holder ValueAct, could gain wider currency.

On the other hand, as we pointed out in the summer, ValueAct has a more consensus-seeking style than the high-pressure, confrontational one many US activist funds are known for.

And with RR stock still trading moderately above market forecasts of its break-up value, we think it’s likely to stay in one piece for longer.

That means its best plan is to reorient itself to the faster-growing short-haul market, which it pretty much dumped a few years ago.

And cost cuts.

None of that will be quick.

And opportunities will be missed.

At the same time RR is trading just 7 basis points above (AKA the same as) median 5-year intrinsic valuation and rated 12.48 time 2016 EPS.

BAE shares are at an easier 11.51 times, and 13 basis points above 5-year IV.

Institutional investment tends to be reduced in staged fashion, suggesting further medium-term reduction of Rolls-Royce holdings.





Eurofighter Typhoon, pictured at Putra World Trade Centre, Kuala Lumpur, Malaysia, October 2011



Potential >$1bn asset sale

It’s little wonder investor flight from RR may have been destined for BAE, lifting RR’s rival to the top of the FTSE and sending Rolls to the bottom.

Their divergence could be subtler than it looks though.

Both warned on profits on Thursday.

BAE said it no longer expected earnings to grow in 2015 with reduced Typhoon fighter jet production on the horizon.

Typhoon sales were now seen at £1.1bn in 2016 from £1.3bn before.

However the market had already discounted BAE’s February earnings forecasts against the low chance of a big Saudi order coming through this year.

And BAE also stated that the orders environment was improving, with a robust backlog at the half year of £37.3bn.

Additionally, reports emerged on Thursday that BAE was in advanced talks to sell less-profitable government consultancy operations in the US.

The mooted buyer is private equity firm Veritas Capital Management, at a price above $1bn.

VCM has yet to secure financing, but if the assets are disposed of, they’ll bolster BAE’s already impressive cash base.

2016 free cash flow is forecast at £553m, and dividend yield at 4.9% vs. RR’s 3.3%.

BAE’s not out of the woods by any means, but then which A&D company is?

Our aggregate industry model for the diversified UK sector has net income dropping 63%.

But BAE is now likelier to get a bigger share than RR.



From a technical view, BAE’s medium-term outlook hinges on ability to beat persistent sellers between 500p and 475p.

In March, the stock got close to all-time peaks at 556p, last seen in 1998, and this attracted bears.

Assuming the stock retakes 475p resistance from August and October, 481p and 488p would be next before the crucial 61.8% marker (499p) of the year’s decline to August lows.

Thursday trade could prove to be a flash in the pan, but strong consolidation since late October close to the day’s lows argues otherwise.

A close above previous resistance straddling the 100-day moving average would prove the stock is clear for take-off.





Please click image to enlarge



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