3 global picks in aerospace and defence

British engine maker Rolls-Royce leads a group of global aerospace and defence companies that boast competitive advantages and compelling value, according to Morningstar analysts.

Morningstar is bullish on the sector, with seven of the nine large-cap companies within the category holding wide moats, among them jet maker General Dynamics and France’s commercial passenger powerhouse Airbus

Meggitt PLC (XLON: MGGT), a UK-based company that manufactures components for the aerospace and defence industries, and well-known automotive and aircraft component and engineering firm Rolls Royce both hold narrow moats.

Rolls at a hefty discount

Rolls Royce (XLON: RR.) is Morningstar's most undervalued pick within the category, currently trading at a 23 per cent discount to its closing price of 685.40 pence on the London Securities Exchange.

"Shares are attractively priced relative to our new valuation," Morningstar equity analyst Joachim Kotze said late last year. He lowered his fair value estimate to 925 pence a share, from 1070 pence in mid-November on expected increases in development spend and a need to boost cash reserves.

Rolls Royce's defence and power systems businesses provide for steady profit and cashflow generation. The civilian aerospace segment is a key driver of the investment outlook, says Kotze.

British engine maker Rolls-Royce is Morningstar's most undervalued pick within the category, currently trading at a 23pc discount

Rolls-Royce this week announced it has opened a site in Bristol where it will develop jet engine technologies that reduce emissions. The company has pledged to achieve zero emissions at its operations and facilities by 2030.

Within its defence business, the "onerous and complicated certification process limits competition, and therefore, we assign a narrow moat to the defence business based on intangible assets stemming from technical know-how," he says.

More than 50 per cent of the company's defence revenues come from service provision, particularly the sale of spare parts to third-party contractors who maintain the fleet of some 16,000 engines globally.

Rachel Winter, investment director at UK-based fund manager Killik & Co also likes Rolls Royce. Rolls-Royce is better-known for its exposure to commercial aircraft, but Winter notes it is very successful in military and defence.

"A lot of the nuclear reactors in submarines are serviced over the long term by Rolls-Royce [and] about 20 per cent of the company's revenue is allocated to defence," Winter told Morningstar UK editor Holly Black earlier this week.

Of that defence revenue, about half comes from the US and the rest is divided quite equally between the UK and the rest of the world.

"So, quite diverse there geographically. And again, I think this company stands to benefit if allies of NATO do start to spend more on defence," Winter says.

Business jets and battle systems

New York Securities Exchange-listed firm General Dynamics (XNYS: GD) – which makes business jets as well a range of vehicles and combat systems for the US military – is considered fairly valued by Morningstar analysts.

"General Dynamics' ground vehicle business, combat systems, is poised for significant growth thanks to international work," says Morningstar US associate equity analyst Burkett Huey.

"In addition, the US defence budget is returning to growth, and we believe that the US Army will begin a long-delayed vehicle modernisation program."

General Dynamics, which makes business jets as well a range of vehicles and combat systems for the US military, is considered fairly valued

The company's "entrenched, competitive" position in shipbuilding and ground combat vehicles and its strong Gulfstream business aircraft brand is a key reason for Morningstar's wide moat rating.

GD's marine systems, a large proportion of which is underpinned by its duopoly in submarines and warships, accounts for around 25 per cent of total revenue.

Huey doesn't anticipate any new competitors within the US shipbuilding segment occupied by GD. "It benefits from efficient scale, resulting in solid returns on invested capital across its shipyards," he says.

The company was trading at US$181.61 on Thursday's close, slightly below Morningstar's US$188 fair value estimate.

Choppers and passenger planes

Airbus (AIR) also trades at a modest discount to Morningstar's fair value estimate, its last closing price of 134.92 euros, around 7 per cent below the fair value estimate set by Morningstar's Huey in December.

Known mostly for its making passenger aircraft, the French company also generates about 25 per cent of its revenue from defence.

Huey increased his fair value estimate for the aircraft builder to 144 euros a share, from 123 euros, and maintained his wide moat rating.

"The big drivers of our valuation for Airbus are the rate of aircraft production increases in the narrow body market and the margins on these aircraft," he says.

Known mostly for making passenger aircraft, Airbus also generates about 25pc of its revenue from defence

Killik & Co's Winter also holds a positive view on the firm, emphasising its market share of around 50 per cent in the manufacture of helicopters.

"They're particularly exposed to Europe and I think that's quite a good thing at the moment, because the US has been quite critical of European NATO countries for not spending enough on defence," she says.

Many major European countries are spending below the 2 per cent of GDP minimum NATO allies are expected to commit to defence, says Winter.

"The US spends about 3.5 per cent, but Germany, France, Spain, they're spending much less than 2 per cent.

"And I think the US will start to put some pressure on for those countries to spend more. And that's got to be good for European defence companies, such as Airbus."