BAE, Melrose and Rolls Royce – opportunity ahead?

Some of the UK’s largest aerospace and defence companies recently reported full-year results, and there were some strong 2022 performances.

Broadly speaking, profits were up across the board. The defence sector benefitted from increased defence spending globally, and this is likely to be a sustained upcycle due to rising tensions and the ongoing Ukraine crisis.

Defence companies uniquely sell to the government and typically enjoy a pricing structure where they can pass on increased manufacturing costs to their customers. But bear in mind that long term, defence budgets go up and down, so the current raised budgets are unlikely to continue indefinitely.

Aerospace saw a robust recovery in commercial air travel last year, with roughly a 50% increase in the number of flights compared to 2021 levels. This uplift provided a much-needed respite from the stranglehold that COVID-associated impacts put on the sector.

Confidence has started to trickle back into the sector, but there’s still scars on balance sheets which will take time to heal.

Remember, investing in individual companies isn't right for everyone. That's because it's higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you're investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

BAE Systems – defensive diversity

BAE is in the defence business – manufacturing heavy-duty equipment like fighter jets and aircraft carriers, as well as a wide range of electronic systems to complement them. 

A differentiating strength of the group is its diverse geographic footprint. Amid escalating global tensions, lots of governments are raising their defence budgets. We’ve already seen full-year revenues rise 8.9% to £21.3bn in 2022. Given its exposure to many of the world’s largest national defence budgets, we think BAE’s well positioned to benefit should defence spending increase over the coming years.

Underlying operating profits landed in at £2.5bn, up from £2.2bn the year before. And free cash flows of £2.0bn last year meant that despite increased dividends and share buybacks, the net debt position improved. It also leaves room for BAE to funnel some cash into strategic acquisitions in key growth areas like Electronic Systems, where developments are easier to scale up.

Dividends vs share buybacks – what investors need to know

2022 sales by customer location

Source: BAE Systems 2022 annual results presentation.

Record order intakes in 2022 means the order book’s sitting at a hefty £59bn. And as these are typically long-cycle, with revenues spread over several years, it gives BAE multi-year revenue visibility. This could reduce the impact of the ups and downs of a changing geopolitical landscape.

A strong pipeline of prospects makes us cautiously optimistic that the order book will continue to grow in 2023.

However, there are headwinds to be mindful of. The group’s Electronic Systems division, which accounts for more than 20% of group sales, is already experiencing a shortage of high-skilled labour. There doesn’t appear to be a quick fix for this issue, and a step-up in demand will likely put more strain on this problem. 

Reliable revenue streams should help BAE reach its own target of 4% to 6% underlying operating profit growth, as well as underpin the prospective 3.0% dividend yield. But remember, yields are not a reliable indicator of future income and any shareholder returns including dividends are never guaranteed.

There is room for the bottom line to grow further, but only if the group can continue to run a tight ship. Any operational slip-ups could put downward pressure on the valuation, which currently trades ahead of the long-term average.

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Melrose – divide and conquer?

Melrose specialises in buying, improving, and selling on ailing manufacturing businesses. The group saw its full-year underlying revenue rise by £928m to £8.2bn. This was driven by growth in both the Aerospace and Dowlais segments, which rose 16.3% and 10.9% respectively.

On 30 March, Melrose shareholders agreed to demerge the Dowlais segment, which includes the Automotive, Powder Metallurgy and Hydrogen businesses, and will look to complete the demerger before the end of April.

Total underlying operating profit rose from £317m to £480m in 2022, with the Dowlais businesses generating the lion’s share of total group profits.

Underlying Operating Profit/Loss by division

Source: Melrose 2022 annual report.

Dowlais will maintain a similar shareholder return programme as that of the existing business. This means they’ll move forward with targeted acquisitions, improve them, then aim to sell them on for a profit – which is shared out among investors. 

But that’s easier said than done. Neither automotive nor aerospace is a particularly great place to hide when the economy’s in a down cycle.

Generous dividends and buybacks in 2022 more than offset net cash inflows, which pushed net debt levels up from £950m to £1.1bn. Plus, free cash flow fell from an inflow of £125m to an outflow of £8m last year. This means it could be some time before the group can make meaningful purchases without further stretching the balance sheet, or asking shareholders to dip into their pocket.

Melrose is currently trading at 15.3 times expected earnings and above the long-term average. This reflects investor confidence in management’s ability to pull this off.

There’s also a prospective 2.0% dividend on offer, but as always, yields are variable and not a reliable indicator of future income. And given the execution risk ahead, potential investors should be prepared to strap in for a volatile ride.

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Rolls Royce – returns to flight

Rolls Royce produces aeroplane engines for larger, long-haul planes. A huge amount of its revenue comes from servicing those engines, with business based on how many hours those engines spend in the air. As air travel increased last year, this helped the group’s full-year underlying revenue rise by 15.9% to £12.7bn.

While these so-called engine flying hours (EFH) were up over a third in 2022, that’s still only around two thirds of 2019 levels. We think it'll be another couple of years until EFH are back to pre-pandemic heights. Just how quickly Rolls regains altitude remains to be seen, and there could be some turbulence along the way.

Largely due to increased servicing levels, underlying operating profit soared 57.5% to £652m – showcasing just how important the activity is to Rolls. It’s helped the Civil Aerospace division jump back to profitability this year, while the group’s other divisions saw smaller changes in performance. Power systems also made a positive contribution, while profits in Defence were down and losses widened in the New Markets division.

Underlying Operating Profit/Loss by division

Source: Rolls Royce 2022 annual results presentation.

The group became free cash flow positive again, bringing in £0.5bn in 2022 after it watched £1.5bn of cash walk out the door the year before.

However, the balance sheet is still carrying around some scars. Rolls’ leverage, measured by its net debt to cash profits (EBITDA) ratio, is still well above most of its peers. Perhaps it’s no surprise that analysts aren’t forecasting a return to the dividend list this year.

While it appears the worst might be over for Rolls, the group still faces some short-term challenges. Improving the balance sheet health will be key to restoring investor confidence.

Navigating a potential economic downturn won’t be an easy task either. The group’s already been through several cost cutting rounds, so we don’t think there’s much fat left to trim on this front. Further improvements to the bottom line will likely have to come from other avenues.

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This article isn't personal advice. If you’re not sure if an investment is right for you, seek advice. Investments and any income they give you can fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future and figures and ratios shouldn’t be looked at in isolation.

Unless otherwise stated, estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates aren’t a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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