Interactive Investor

Rolls-Royce and BAE expected to star again in 2024

Both blue-chip stocks have had a strong year, although none have done better than Rolls. And now there are further upgrades. Here are the latest ratings and price targets for the duo.

12th December 2023 12:45

Graeme Evans from interactive investor

New price targets valuing Rolls-Royce Holdings (LSE:RR.) at £4 and BAE Systems (LSE:BA.) at a new record have been revealed as the stocks benefit from the strongest growth cycle in a decade.

The pair have been backed for further progress in 2024 after Bank of America and Deutsche Bank named them among their preferred stocks in European aerospace and defence.

Both City firms believe Rolls shares have the potential to continue their spectacular recovery, having risen by 200% from this year’s starting point of less than 100p.

BAE is up by a more modest 20% this year, having fallen back from November’s record high.

The banks have price targets of 400p on Rolls shares, while Deutsche Bank’s view on BAE has improved from 1,220p to 1,290p and Bank of America’s from 1,245p to 1,280p.

The latter told clients on Monday: “We see multiple opportunities for re-rating in 2024 amidst the strongest civil and defence growth cycle seen in a decade.”

As well as the upgrades for Rolls and BAE, the US bank has lifted its targets on GKN Aerospace owner Melrose Industries (LSE:MRO) by 70p to 720p and Babcock International Group (LSE:BAB) by 19p to 565p.

In civil aerospace, the bank’s analysts expect that 2024 will be a year of margin expansion after 2023’s focus on supply chain normalisation.

It said: “We see the outlook as extremely positive for civil, driven by continued strong order momentum, a decade of visibility and a hiatus in the investment cycle.

“We think this is supportive of valuation mid-term. As a result of the strong growth outlook through 2026, we see further potential for re-rating in 2024.”

Rolls is expected to resume dividends in 2024 once it achieves investment grade rating, with Bank of America seeing “significant room” to increase shareholder returns mid-term. Its forecasts include £2.2 billion and £3.7 billion of share buybacks in 2026 and 2027 respectively.

The bank added: “We view the valuation as attractive versus peers given improving free cash flow generation, and the balance sheet is no longer a concern.

“As one of the cheapest civil aerospace assets globally today, we see potential for strong re-rating in 2024.”

On Friday, Deutsche Bank upped its target price on Rolls from 320p to 400p to reflect the rollover of its own estimates to include the 2026 financial year.

It also follows last month’s guidance by chief executive Tufan Erginbilgic after he targeted 2027 free cash flow of £2.8 billion-£3.1 billion, some 30% higher than the City consensus.

The detail of that briefing also prompted UBS to increase its base case from 350p to 400p on Friday, reflecting stronger margin assumptions and the resulting 10% improvement in earnings per share estimates across its coverage period.

It believes there’s potential for Rolls’ engine flying hours to surprise in 2024 given the consensus models only a 13% increase year-on-year after a rise of 34% in 2023.

UBS raised a few eyebrows in August when it highlighted an upside scenario of 600p at a time when Rolls was trading at just above 200p. It remains comfortable with that position, while it has lifted its downside scenario to 150p.

On BAE, the defence industry fundamentals are expected to remain supportive given the prospect of another year of heightened geopolitical tension.

The sector has traded at elevated forward multiples since Russia’s invasion of Ukraine in early 2022, although protracted budget negotiations in the US and in Germany have weighed on valuations more recently.

In the longer term, Deutsche Bank said the US presidential election in late 2024 could have a profound impact: “A Trump victory may revive discussion of a US exit from NATO and accelerate European defence investment to guarantee its safety, giving the industry another leg for growth.”

While Bank of America doesn’t see scope for a material re-rating across the sector, it sees several selective opportunities through BAE, Rheinmetall AG (XETRA:RHM), Saab AB Class B (OMX:SAAB B) and Babcock.

Its support comes as BAE bolsters its electronic systems portfolio through the £4.4 billion acquisition of space systems business Ball Aerospace, a deal that completes in the first half of 2024.

Bank of America expects BAE to deliver another year of 6%-plus organic revenue growth and sees the company returning about 6% of its market value to shareholders next year.

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