Indeed, since the beginning of August 2013 BAEs shares have gained 7.3%, while Rolls shares have slumped by 33% following a series of profit warnings, a management shake-up and a lack of corporate direction.
However, after BAEs gains and Rolls losses, BAE now looks expensive but Rolls appears to be undervalued.
Rollshasmade many mistakes over the past few years. These errors include a wasteful 1bn stock buyback, diversification into industries where the company has littleexperience and a slow transition to new product lines.
But now the company is trying to draw a line under these mistakes and move on. Luckily, Rolls has world-leading reputation and multi-billion dollar order book already in place to support this turnaround.
Specifically, at the end of the first half of this year, Rolls order book stood at 76.5bn, equal to more than six years worth of sales at current production rates.
And with a new management team in place, along with an activist hedge fund ValueAct, which has a reputation for unlocking value from struggling companies Rolls restructuring should yield lofty returns for investors.
Warren East, Rolls new CEO, has stated that the companys restructuring plan will be announced sometime over the next 12 months. The programme will be focused on cutting costs, improving cash flows and improving performance at Rolls keyaero-engines division.
Rolls aero-engines division is where the real value can be found. You see, Rolls shares a duopoly withGeneral Electricin wide-body jet engines, and the barriers to entry for any newcomer would be formidable. In this business, Rolls earns a20% return on invested capital. However, Rolls sales arentone-offs: the company sells its engines at cost, or at a loss, but signs lucrative maintenance contracts over the life of the power system. These maintenance contractsproduce income for years after the initial sale.There are few other companies with such a lucrative business model.
Unfortunately, the business benefits of the long-term care business model have been annulled by Rolls poor decision to plough cash into its marine engine and power-generation businesses, competitive sectors that are being encroached by low-cost Asian players.
Nevertheless, with an activist on board, and new management in place, its likely that Rolls will re-align its business model. This transition should unlock value for investors.
Struggle to move higher
Rollshasplenty ofroomto manoeuvre, restructure and return to growth. However, BAE appears to be fully valued at present.
For example, BAEs main peers, the likes ofGeneral Dynamics,Lockheed Martin,Northrop GrummanandRaytheon Co, trade at an average forward P/E of 17.6 compared to BAEs forward P/E of 17.3. City analysts dont expect BAEs earnings to grow this year.
Moreover, these four leading defines contractors all reported a higher return on shareholders equity than BAE during the past year. ROE averaged40.4% for the group during 2015, compared to BAEs 39.8%.
The bottom line
So overall, BAE looks to be fully valued at present levels, but with new management in place and a solid base to grow from, Rolls Royce could have a bright future ahead of it.
But if you don’t believe that Rolls can turn things around,our top analysts here at The Motley Fool have discovered a companythat they believecould see its sales increase by300% to 500%over the next few years.
Our analysts believe that the company in question is one of themarket’s hidden gems.And all is revealed in ournew free report.
So, if you’re interested in finding out more, download ourfree report today. The report will be delivered to your inbox immediately and there’s no further obligation.
This is something you do not want to miss!