Time to take to the skies – but with which stock?

i) Rolls Royce is at 713p on news that EEC competition authority is looking at aviation engineering support contracts, another potential headwind to contend with.

ii) AIG on the other hand, at 570p, has tail winds behind its prospects and share price. Time to chase AIG but not Rolls Royce at this stage, methinks.

Rolls Royce at 713p: a hold

Today, whilst scanning the market intelligence reports over a fine cup of coffee in a small Italian café – presided over by a loquacious neo-Mussolini maestro and proprietor – I noted, cappuccino frothing at the mouth, a report linking the names of Rolls Royce (RR.) and International Consolidated Airlines (AIG) – emotionally still thought of as ‘British Airways’ by veteran investors and market watchers, like me – even though it is partly Spanish, headquartered in Madrid and states its share price and accounts in Euro’s. It is also now of course, also partly Irish following the acquisition of Aer Lingus.

The link between them was of course the news that the EEC competition authority investigators have been seen hanging about Rolls Royce asking questions; or rather, to be precise, sending them questions to answer, reportedly about the business practices and contractual terms they employ in their maintenance deals with airlines. It seems that Willy Walsh of IAG has been complaining about a lack of competition in aero engineering support contracts, a business which is increasingly important to Rolls Royce. To be fair, the EEC competition authorities are looking at others but that suggests a big industry-wide enquiry which has prompted fears in the market that Rolls Royce might eventually be found guilty of overcharging. Certainly, the Rolls Royce share price, having broken out from its recent downtrend, fell 1.77% to 713p on the news. So what does one make of these two shares now?

Turning to Rolls Royce first, the share price peaked at 1,061p back in May and in the last four months or so, it has been as low as 636p. They rallied from that point – arguably breaking out of the last sharp down trend in which the share price has fallen by nearly 40% between July and September. The market has also fallen during that period but inevitably Rolls Royce has fallen more – something which in principle but in nothing else, makes the shares of such a quality business initially attractive as a market underperformer. Over the last month Rolls Royce shares have fallen while the FTSE100 Index rose by more than 3%, thanks in large to the stories about the men (and women of course) of the EEC competition authority. So, will the share price continue to rise in a breakout, as suggested by the chart, or are we now in for another big leg down as the market gnaws on worries?

The first step is to have a look at the assets and liabilities of the company in relation to the much reduced share price which has done much of the work in possibly making Rolls Royce equity attractive.

The balance sheet shows a picture of falling cash levels, which saw last year’s net cash position of £666 million reduced to a net debt position of £643 million in June. Even more unhelpful, operating cash flow was in negative territory in the half year to 30th June 2015. We have a situation where revenue is holding up but net margins are falling in the headwinds of declining demand from mine and oil exploration customers for industrial turbines etc. Moreover, as I noted last July, there seems to be a deferring of Trent aero-engine orders for the awaited more efficient Trent 7000 engine. The market, after seeing no growth in earnings last year, is now consensually focussing on falling estimates for earnings next year (minus 17%) and the following year (minus 19%), which means that at a share price of 713p (last seen) the shares are selling on forward estimated price to earnings ratios of 14 times for this year and 17.4 times for next year.

Moreover, the market is estimating progress in the dividend payout per share even if that progress is a snail pace 22.88p for the current financial year and 22.94p for next year. That suggests that the shares are reasonably and fairly valued at the moment, given the long term nature of the Rolls Royce business. It is to be added that on the basis of the last June 30th balance sheet the company had estimated assets per share of some 290p or around 40% of the share price of 713p. That nicely reduces the prospective, conventional estimated price to earnings ratios (see above) from 14 and 17. 4 times to ‘earnings only’ valuations of an indicative 8.4 times and 10.5 times.

Returning to the share price charts, to give them a subjective viewing as to where the share price of Rolls Royce might go next, I conclude that it has bounced off the bottom rung of downtrend support line, which suggests that the share price has room for a rally in what remains a basic downtrend. However, I reasonably suppose that any such rally may be cut short by concerns about the possibility of some EEC report that could depress cash flow and earnings even more next year. I am convinced that on a three to four year view, this current share price will look cheap. But that does not of course, preclude the share price from getting a bit cheaper whilst this long term tanker of a company is turned around from head winds by tail winds. So I mark it as a hold.

AIG on the other hands has the tail winds behind it, as it gives evidence no doubt to the EEC competition investigators…

IAG  at 570p: Very attractive          

I see from my notes that I last had a look at International Airlines Group back in May having previously seen it as an oil price play and as a stock to be bought on that basis. By May I was influenced by the big rise in the IAG share price, against the background of a traditional weaker market in summer (go away in May etc) and growing political uncertainty at home in front of the UK general election and the knowledge that quantitative easing would be coming to an end. Like most macro economic and political forecasts, it was not wholly accurate. However, the instinct seems to have been because the IAG share price has fallen back from the May high of 630p. The price fell below 500p in July and has since recovered to 576p (last seen), almost exactly where it was back in May. So as it makes its approach through the 600p level to the previous high of 630p, will the share price soar through that barrier or start heading south again as it did four months ago?

In terms of share price technicalities, the perspective of a three year chart shows that the AIG share price is moving up, bouncing off a lower rung upward trend support level. That looks pretty much likely to take it through previous resistance at 630p into new territory suggesting that 750p is within reach.

Looking for corroboration for that technical possibility, I note that the Euro (the currency in which the company accounts for its operations and in which the shares are priced) is still weak against the dollar (the currency in which much of its profits are made), despite the unrequited promise of QE easing in the US and UK. The latest news out of OPEC seems to support the view that the oil price is not going to jump any time soon. Moreover, the addition of the Aer Lingus business will increase the company’s footfall, market share and economies of scale, given its hard won reputation for making airline companies efficient despite the odds. (In stark contrast to one of its competitors, Air France, whose workers – or some of them at any rate – quite literally had the shirts off senior company executives as they fled for safety.) These are the same kind of economies that are also propelling discounters in the UK high street to success.

The belief that these underlying, hitherto benign conditions seem likely to continue is reflected in the market consensus estimates. Top line sales revenue this year is estimated to grow by over 9% fuelling an estimated 74% increase in earnings. Next year, the market consensus expects only a 3.5% rise in top line sales revenue to Euros 22,826 million; handsome enough to fuel a further estimated 27% increase in earnings next year.

The happiest symptom of the company’s financial health comes with the expected return to dividend paying ways. For years, the old British Airways share price was more volatile and speculative because it had no dividend payment to steady the ship, particularly on the downside. A dividend of 14.2 Euro cents is now estimated for this year, giving a dividend of 1.9% on the current price (576p last seen). If the market consensus is correct in its estimates, the dividend pay out will rise by over 50% to 21.6 Euro cents next year, giving at the last seen price, a prospective estimated dividend yield of 2.9%. This development raises the quality of the share, and in turn implies a much better quality of earnings.

The financial history of AIG over the last three years has been majestic in its progress. Operating cash flow rose from Euros 399 to Euros 1.86 billion in December, (on current exchange rates an estimated £1.37 billion). As at the June 30th 2015 balance sheet, cash held was an estimated £4.75 billion, again having risen massively. Equity (net assets) in June were an estimated £3.53 billion. That suggests the shares are selling on around 8 times annual cash flow and that net attributable assets are worth about 175p a share. That is in part due to operational and financial gearing working in relation to low costs and rising sales. Equity in June looks as though it was geared by 200% of total debt. Ideally, that should be brought down either by retentions or a rights issue.

The AIG share price looks as though it will be a strong performer and is backed by attractive financial fundamentals. But do not forget the gearing.