Rolls-Royce: The Power Share

LONDON -- A spate of contract wins at Rolls-Royce (LSE: RR.L  ) is a reminder to investors that it is not just engaged in aerospace. Within the space of the last few days, the company -- which likes to describe itself as a provider of power systems and services -- has announced three new deals in diverse segments across the world.

Perhaps the most significant is the contract to power the U.S. Navy's future hovercraft fleet, which will transfer men and material from ship to shore. It also won an order to power offshore supply vessels to Brazil's oil and gas industry and has been appointed to supply safety instrumentation to modernize plants for China Guangdong Nuclear Power Corporation.

In truth, civil and defense aerospace together make up about 70% of Rolls-Royce's business. The civil side alone accounts for more than half of turnover, though somewhat less of total profit. The marine business is about 20%, and the energy business chips in most of the remaining turnover, though it is currently loss-making.

The long view
But Rolls-Royce is a business that has grown by taking a long-term view toward research and development, developing new technology and new applications for it. The non-aerospace business represents investment in the future. It's an approach that has paid off handsomely: The company boasts a customer base of more than 500 airlines, 160 armed forces, and 4,000 marine customers. More than half its 11 billion pound turnover represents the provision of after-sales service that provides an ongoing income stream, and the order book covers more than five years' worth of turnover.

The strategy is in marked contrast to the other major FTSE 100 defense contractor, BAE Systems (LSE: BA.L  ) . A group of its investors, led by its largest shareholder, Invesco Perpetual, has just written to the board seeking the resignation of the chairman following the company's failed plan to merge with Airbus manufacturer EADS.

Those shareholders fear BAE has no coherent strategy and has simply pursued growth through a series of acquisitions. Indeed, it has spent a net 14 billion pounds on mergers and acquisitions since 1995. The company bought and sold carmaker Rover, and in 2006 it sold its 20% stake in Airbus only to contemplate re-entry into that business with the EADS merger.

Despite recent efforts to develop new geographic markets and diversify into areas such as cyber-security, its strategy has made it highly dependent on U.S. and U.K. government defense procurement, both of which are under severe financial constraints.

End result
The end result is that since 1989, Rolls-Royce's total shareholder return has been twice that of BAE's.

That's a telling statistic. Rolls-Royce's quality is reflected in its share price: It trades on a much higher price-to-earnings ratio and a lower yield than BAE.

Company 

Historic P/E

Historic Yield

Prospective P/E

Prospective Yield

BAE

7.5

6%

7.8

6.2%

Rolls-Royce

19.7

2%

15.2

2.3%

BAE is much the cheaper stock, and in the short term it might be the better buy. But if Rolls-Royce repeats its outperformance over the long term, then it would produce better returns for investors, delivered through its share price, rather than dividends. Note how Rolls-Royce's prospective P/E is considerably lower than the figure based on historic earnings, indicating the market expectation that its earnings will grow faster than BAE's.

The two companies neatly characterize two different investment styles. High-yield investors -- such as Invesco Perpetual's Neil Woodford -- see value in BAE. Investors seeking growth might prefer Rolls-Royce.

Despite their different characteristics, both companies have much going for them and could well justify a place in investors' portfolios. If you want to learn more about building a portfolio, I recommend you read the Motley Fool's guide: "10 Steps To Making A Million In The Market." It's free, and you can download it to your inbox -- just click here.

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Tony owns shares in BAE Systems but does not own any other shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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