Rolls-Royce (LSE:RR) shares are on a dismal run. After failing to recover from the recent travel bans, the company has struggled to reach pre-pandemic highs. And its restructuring efforts to counter losses, although promising, will take time to be profitable.
With the worst of the pandemic seemingly over, investors expected Rolls-Royce shares to recover quickly. Brief surges in July and October 2021 were encouraging signs at the time. But the economic windfalls from the pandemic seem to have pushed the company out of favour.
Despite recording a £513m profit last year and securing new deals, the engineering firm has been spending a lot on R&D. The new defence and power projects are cash-intensive operations that will take years to develop.
This, coupled with the loss of some core employees, including CEO Warren East, are signs that the recovery could be laboured.
However, I have identified an exciting FTSE 100 engineering firm with a strong focus on defence that I think looks like a much better long-term option right now. Analysts expect governments to hike their already sky-high defence budgets in response to the war in Ukraine. And I think top stocks in this industry could be promising picks for my portfolio.
British defence giant
BAE Systems (LSE:BA) is the largest defence contractor in Europe and one of the top R&D companies in the sector. The company is the seventh-largest defence contractor in the world with partnerships with governments in the US, the UK, Germany and Australia. In defence, BAE Systems has established positions in the air, maritime, land and cyber domains.
In a trading update released today, the company highlighted several key deals. These include a contract for the management of the US Navy’s C5ISR systems and an 11-year contract to support the UK’s Royal Air Force Hawk fleet.
The company could also benefit strongly from the US’s new defence spending budget of $773bn. The country accounts for 46% of BAE’s sales and the new budget could further boost future revenue. Given tensions in the region, BAE expects defence spending in Europe to increase too.
The group’s outlook for 2022 remains positive. The board estimates a total sales boost of 2%-4% and underlying EPS growth of 4%-6%. Free cash flow in 2022 is set to exceed £1bn. This could help upgrade its 3.32% dividend yield.
And this financial stability is why BAE has outperformed Rolls-Royce in the market. In the last 12 months, Rolls-Royce shares are down 17.7% while BAE shares are up 51%. And BAE shares look much cheaper trading at a price-to-earnings (P/E) ratio of 13 times compared to RR’s P/E ratio of 57.
Some concerns and my verdict
With rising tensions, the UK government is keeping a close eye on the defence industry in the country. The bid for British firm Meggitt by US-based Parker Hannifin has come under government scrutiny on national security concerns. And since BAE works with governmental agencies across the world, rising tensions could force trade sanctions that would affect BAE’s revenue.
However, the company has a huge order book and is working on key defence tech for the future. The board is confident in delivering growth while maintaining dividends. And I think BAE shares are a much better long-term option for my portfolio than Rolls-Royce shares.
