Rolls-Royce’s recovery has wings

While Donald Trump’s victory in the US election was unpopular, there will inevitably be some winners from his Presidency. One sector which could record higher profitability as a result of his win is the defence sector. His promise of greater military spending and the possibility of rising defence spending among NATO members means the sector could reverse years of cutbacks.

Similarly, Brexit may not be popular among vast swathes of the UK electorate. However, its effect on sterling has been significant and highly beneficial to a number of UK-listed shares. It could even mean acquisitions undertaken by overseas firms are more likely.

One company which is therefore worth buying in my opinion is Rolls-Royce (LON:RR). Alongside the two catalysts of Trump and Brexit, it also has a sound strategy and fair valuation which could send its shares higher over the long run.

Trump’s effect on defence

Although this week’s focus has been on the building of a wall between the US and Mexico, Trump’s Presidency is set to boost spending on defence. While details are in short supply at the moment, Trump’s comments during the election campaign indicate he will seek to bolster the US’s military capability.

This is not only because he feels the US military needs to strengthen in order to protect against terrorism. It is also likely that he feels it is a sound means of delivering a stimulus to the economy. Therefore, he has stated during the campaign there will be up to 90,000 more soldiers, 100 more fighter jets and a strengthening of the country’s nuclear capabilities.


In addition, Trump’s comments regarding NATO members not pulling their weight are likely to increase global defence spending, in my view. So far, his campaign promises are being delivered, so NATO members may decide it is better to increase spending to 2% of GDP, rather than risk a lack of protection from the US military. As only 5 of NATO’s 27 members spend 2% or more on defence, this could add up to a large amount.

Since Rolls-Royce is the second largest provider of defence aero-engine products and services globally, it could benefit from a Trump tailwind. This could help reverse years of austerity which have contributed to recent profit warnings and a disappointing share price performance.

Brexit’s effect on sterling

Rolls-Royce will also benefit from weak sterling. Already, its financial performance has been lifted by the pound’s weakness, since it is a major exporter which reports in sterling. In my view, the trend for a weaker pound will continue over the medium term.

Once negotiations between the EU and UK commence, uncertainty could move up a notch because the chances of a ‘hard’ Brexit are likely to increase. Neither side will concede on the issue of free movement according to recent statements, so the chances of a smooth or particularly amicable ‘divorce’ seem remote in my view.

…I would not be at all surprised if Rolls-Royce was bought out by an American or other foreign industry peer.

Therefore, higher uncertainty could lead to an even weaker pound. As well as improving Rolls-Royce’s profits and overall financial performance, I believe this could lead to the potential for a takeover.

Borrowing rates remain low in the US, but are on the rise. Given the wave of optimism throughout the defence sector, I would not be at all surprised if Rolls-Royce was bought out by an American or other foreign industry peer.

Strategic changes

Rolls-Royce has a sound strategy in my view. Its long-term growth prospects are relatively bright due in part to the launch of new products such as the Trent 7000 aircraft engine. This could help the company to gradually build towards a 50%+ share of the installed widebody passenger market.

In the short run, its profitability may be hurt by reduced orders for the Trent 700, but investment in its long-term future is the right move, in my view.

Alongside new products, Rolls-Royce is changing its business in order to become more efficient. For example, new management has kept to its 2014 and 2015 initiatives to reduce manufacturing and back office costs within the Aerospace and Marine segments.


Management are now on track to cut costs by £145 million by the end of 2017. Additionally, the new transformation programme will simplify the business and create incremental enduring cost savings of as much as £200 million per annum from 2018 onwards.

The combination of investment and efficiency should allow the company to register growing profitability. For example, in the next two years its EPS is forecast to increase by 43% and 6% respectively.

Given its P/E of 29, I therefore feel it offers fair value for money. Even at a premium of 20% or 30% above today’s price I would probably still consider it fair value, which increases the chances of a takeover approach.

Outlook

Undoubtedly, Rolls-Royce has been a tough place to invest in recent years. It has registered profit warnings, faced tough trading conditions and lacked a clear growth strategy.

However, given the likelihood of increased spending on defence among the US and other NATO members following Trump’s election victory, I feel the defence industry has a much brighter future. Rolls-Royce should therefore experience a tailwind from increasing demand which could last into the next decade.

Alongside this catalyst is a weak pound, which I feel will depreciate further as Brexit negotiations kick-in. Although a successful period may ensue post-Brexit, I believe negotiations will be tense, uncompromising and lead to greater uncertainty. A weaker pound could make Rolls Royce a more appealing takeover target for a foreign firm, while its valuation makes this scenario even more likely in my mind.

The company’s strategy is sound and should position it for long term growth. Therefore, I’m optimistic about its long term prospects and feel now is the right time to buy Rolls-Royce.