Pent-up consumer demand for travel and a need to upgrade commercial fleets to the next generation of more fuel-efficient planes has helped boost sector sales.

The outbreak of conflict in Ukraine and the Middle East has also created an elevated threat environment, leading many nations to commit to boosting their defence spending for years to come.

Here’s the latest on three companies that look well-positioned to capture some of this increased demand.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments can rise and fall in value, so you could get back less than you invest. Ratios shouldn’t be looked at on their own.

Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

BAE Systems – on the Ball

BAE Systems manufactures military equipment like fighter jets, aircraft carriers and munitions.

Despite being a UK-based company, most of its revenue comes from the US. On an absolute basis, US military spending trumps any other country in the world, so having a solid foot in this market is very beneficial.

Demand for BAE’s products and services has flown in, with more than £30bn added to the order book so far this year.

This backlog of work gives good revenue visibility and highlights the key space that BAE occupies in the defence market. Sales and underlying operating profits are expected to grow at mid-to-high single-digit rates, up from £23.3bn and £2.5bn last year, respectively.

But keep in mind, profitability hinges on an ability to estimate future costs. The long-term nature of many contracts means the risks and costs can change over time, so there are plenty of trip hazards if the group loses focus.

The big story this year was the $5.55bn acquisition of Ball Aerospace, which looks like a good fit to us. Ball has unique positions in critical space and nuclear deterrence technologies. Clearance is moving along as expected, with the deal still set to be completed in the first half of 2024.

Initial expectations were that this would add more than $2bn to BAE’s annual revenues. But if expertise and resources can be used effectively, we see scope for that figure to rise as much as two or three times higher.

BAE’s management of environmental, social and governance (ESG) risk is strong, according to Sustainalytics.

It’s got a product safety policy, a chain of accountability and assesses safety throughout its product development. However, disclosures regarding quality-management standards and external certifications are lacking. We’d like to see improved reporting on business ethics incident investigations.

BAE is currently trading well above its long-run average, increasing the likelihood of ups and downs should any missteps occur. But relative to its US peers, BAE is still trading at a large discount, which we view as unwarranted given its footprint there.

This could be considered a route for exposure to US defence spending at a more reasonable valuation, but there are no guarantees.

The author holds shares in BAE Systems.

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Rolls Royce – fail to plan, plan to fail

Rolls Royce’s CEO, Tufan Erginbilgic, has laid out his plan to reshape the company. He’s issued some impressive mid-term guidance out to 2027, which landed well ahead of market expectations.

Operating profit’s projected to grow to between £2.5-2.8bn by 2027, up from the £1.2-1.4bn expected in 2023. The main driver of this expected uplift is much higher margins in its Civil Aerospace division, with smaller margin improvements in its Defence and Power Systems divisions.

In Civil Aerospace, increased demand for air travel means there’s set to be more of the group’s market-leading engines on wings.

Rolls Royce is also diving into its treasure trove of data, finding its weakest parts, and improving their durability. That should lead to fewer visits to the repair shop, meaning these engines stay in the air for longer, earning Rolls Royce more money.

Free cash flow’s also expected to jump to a staggering £2.8-3.1bn by 2027 too, up from the £0.9-1.0bn expected this year. Disposals of non-core businesses are also part of the strategy. We like this more streamlined focus, and it will free up cash to invest back into more productive divisions.

Improved cash generation also means we expect a significant portion of the group’s debt to be paid off over the next two years. That will strengthen the balance sheet and the market’s now pricing in a reinstatement of dividend payments next year. But remember, no dividend is ever guaranteed.

According to Sustainalytics, Rolls Royce’s management of ESG risk is strong. It’s got a committee in place to oversee ESG issues, and executive compensation is tied to performance on these issues.

But its disclosures of ESG-related issues fall short of best practice, and we’d like to see some improvements on this front.

Overall, we’re cautiously optimistic that the group can reach its mid-term targets, with the potential to outperform some of them. At the current valuation, we think there’s plenty of room for upside.

However, the journey to achieving these targets won’t be straightforward. And any mistakes along the road are likely to be costly for both the company and its shareholders.

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Melrose – engines power the profit outlook

Melrose is a pure-play aerospace business, with exposure to both Civil and Defence customers. It has two main lines of business through its Engines and Structures divisions (think the body of a plane).

We’ve recently seen full-year revenue guidance get lowered slightly, now expected to come in between £3.3-3.4bn. But higher-than-expected margins in the Engines division, which have risen above 25%, more than offset this impact. Underlying operating profit guidance also got upgraded from £375-385mn to £400-410mn.

Demand’s been boosted by airlines looking to upgrade their ageing fleets after several years of pandemic-related underinvestment.

That’s created an order backlog to supply components for more than 12,000 Boeing and Airbus aircraft at the last count, stretching all the way out to 2029. Because of this, we expect revenue to grow at double-digit rates for at least the next couple of years.

Its Engines division is the lifeblood of the company. The group has multiple Revenue and Risk Sharing Partnerships (RRSPs), which typically involve around 15-30 years of investment while it develops and refines unique parts for engine makers. For the next roughly 30 years, we should see the risk profile lessen and the group generate a lot more cash.

Most of the RRSPs are now in this money-making phase. Margins are likely to remain high given the parts Melrose contributes typically last the life of the engine and need very limited maintenance.

Competition in the space is limited and the current demand dynamic is providing strong pricing power.

It’s worth keeping in mind that a large chunk of revenue is based on how long its engines spend in the air. If the economy slows down and air travel drops off with it, Melrose will suffer.

On the ESG front, Melrose's management of ESG risk is strong according to Sustainalytics.

It has very strong environmental policies, as well as robust whistleblowing measures to make sure reports are treated fairly and confidentially. But disclosures regarding ESG issues fall short of best practices, and enhancements should be made.

The valuation has come down from its peak earlier this year, now sitting at 20.6 times expected earnings. That’s in line with the sector average and looks reasonable in our eyes.

There could still be some room for upside if demand continues to increase, but we can’t rule out some turbulence along the way.

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Unless otherwise stated estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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