Jet engine maker Rolls-Royce (LSE: RR) provided one of the few upbeat pieces of news on Wednesday morning, when the Derby-based engineer confirmed that full-year profits should be at the top end of previous guidance.
Although the firm’s expectations for the year haven’t changed since August, the Rolls-Royce share price was up by 4% at the time of writing. Investors appear to be gaining confidence in the group’s recovery and pricing in higher profits.
Solid progress
Technical problems with the firm’s Trent 7000 and Trent 1000 jet engines now appear to be in hand. The company expects less disruption next year and says that production volumes should “increase significantly” in 2019.
Rolls also said that it’s continuing to prepare for Brexit by building up stocks of parts and reviewing its logistics options. The company is also taking some technical measures relating to the approval of jet engine designs in the EU.
The company says that at this stage it doesn’t expect any jobs to be transferred to Europe as a result of these changes. However, plans for 4,600 UK job cuts announced in June are on track. Mr East expects around 1,500 people to have left the firm by the end of this year.
I’m warming to this stock
I’ve always been able to see the attraction of this business as a long-term investment. My concern has been that the shares have seemed too expensive to me.
Mr East’s sure-footed progress is giving me confidence that his medium-term goal of generating £1 per share of free cash flow could be achievable. With the stock trading at about £8 today, this implies a future price/free cash flow ratio of 8. That’s very cheap.
Although Rolls’ 2019 forecast P/E of 29 looks pricey, I’m tempted to rate the shares as a long-term buy at current levels.
A high-flying alternative?
Part of the long-term growth story for Rolls is that airline passenger numbers are expected to continue rising. India, China and Africa all have much lower levels of air travel than the US and Europe, so growth could still be considerable.
Jet engine makers should benefit, but well-run airlines should also profit. The biggest flyer listed on the UK stock market is International Consolidated Airlines (LSE: IAG), which owns British Airways, Iberia and Aer Lingus.
This group has been a top performer over the last decade, but IAG shares have fallen by 10% so far this year. The shares have been pushed down by fears of rising costs, Brexit disruption and slower profit growth.
Broker forecasts are starting to support this gloomy outlook. Although earnings forecasts for 2018 have risen by nearly 10% since December 2017, the outlook for 2019 suggests IAG’s earnings will be flat or slightly lower.
Buy, sell or hold?
The question for investors is whether the shares are cheap enough to discount the risk of falling profits.
Based on 2019 forecasts, IAG stock trades on a forecast price/earnings ratio of 5.8, with a well-covered dividend yield of 4.8%. I believe this is cheap enough to buy. Indeed, I think IAG is a stock that could bounce back quickly if a Brexit deal is agreed.
