EquitiesJul 3 2013

Aerospace industry has potential for take-off

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Get it right and there is serious money to be made. A new Airbus A380 costs around £250m. Each plane is the product of numerous companies and this is where British involvement is interesting. The UK might no longer be the workshop of the world but it has adapted and concentrated on those areas where it has a competitive advantage. Technical design prowess, a critical mass of engineering talent and a concentration of component suppliers mean that aerospace and specialist engineering has had an opportunity to flourish.

While manufacturing might only make up 11 per cent of the UK’s gross domestic product, those companies that remain are proving remarkably resilient. To some extent this reflects the Darwinian process at work. A hollowing out of the heavy manufacturing base in the past few decades and increased overseas competition meant only those areas that were profitable and had a competitive edge survived. Shipbuilding and textiles largely left these shores. The car industry looked set for a similar fate but ironically foreign ownership injected a renewal of capital and ideas that has seen UK car production reach 1.46m vehicles in 2012, according to the Society of Motor Manufacturers and Traders, up 9 per cent on a year earlier, while UK car exports have hit an all-time high. In fact, Jaguar Land Rover is complaining of a shortage of engineers as it ramps up production at its Midlands plant.

So while the UK may have lost control of famous brands and marques to overseas companies, other UK companies have been quietly benefiting from the resurgence of the industry. For them it matters little whether Mini is owned by a British company or a German one (BMW as it happens) so long as the orders for locally-sourced components keep rolling in. GKN, the component supplier is a prime example. It has emerged as a leading supplier of parts to the car and aerospace industry. GKN Driveline business is responsible for many of the axle systems of cars that manage torque and coupling and GKN Land Systems designs and manufactures an array of power train components such as clutches, gearboxes and brakes for agricultural, construction and mining vehicles.

GKN Aerospace has grown rapidly following the integration of Volvo Aero. It produces metallic and composite material components and supplies to key players such as Airbus, Boeing, UTC, GE, Rolls Royce and Snecma, so it matters little which of these giants wins orders as GKN is likely to benefit anyway. The company’s current dividend yield of 2.5 per cent has plenty of room to grow given that the dividend is more than four times covered by earnings and the company has progressively raised the dividend since the financial crisis. Please note yields may vary and are not guaranteed.

BAE Systems is one of the giants of British engineering. Its shares yield a competitive 5 per cent and are covered twice by earnings. It has raised its dividend every year since 2003, which is particularly helpful for investors seeking a rising income stream that offers a degree of protection from the corrosive effect of inflation. Serving both the civil and military sectors, it has developed strong relationships internationally and is viewed favourably by the US Department of Defense, which gives it a critical edge in winning orders.

Rolls-Royce is the other British giant of aerospace. Its dividend is so large that it actually makes it into the top 15 biggest dividend payers in the UK for 2013, according to the latest Capita UK Dividend Monitor. The dividend is paid in C shares but investors can elect to have cash. In terms of the yield on the shares, this represents around 2 per cent and the per share distribution is expected to rise in the coming years, potentially as much as 50 per cent between 2012 and 2016, according to Investec and BofA Merrill Lynch, although this is forecast and not guaranteed.

Rolls-Royce is interesting because it demonstrates how impatient the investment community can sometimes be. This is a pity as one of the principal reasons for a stock market listing is to generate an investor base that supplies equity capital for the company. The senior management at Rolls-Royce recognised back in the 1990s that it would need to invest heavily in engine research and development to ensure that it had the product line-up to attract airlines in the years to come. Engine development is measured in years and for much of the early 2000s the company was unloved as it spent money on research and development. Fast forward to today and the investment is paying off as the orders roll in for its Trent engines.

Other companies involved in aerospace include Senior, which produces turbine engine parts and strengthened support frames attaching wings to the fuselage. It has particular strengths in fluid conveyance systems such as ducting, so next time you wonder how the fuel reaches the engine or critical electronic cables are kept separate from those carrying liquids, you might want to remember this company’s name.

So investors looking for income from equities may do well to consider aerospace companies. Their dividend yields compare favourably to those of so-called defensive sectors such as beverages. GKN currently yields more than Diageo, the spirits group, and BAE Systems is yielding as much as cigarette producer Imperial Tobacco yet it arguably has better growth prospects. It would seem to make more sense to be seeking income from a company that is tuned into the growing aerospace business than a company that is managing decline. Smoking is becoming less prevalent in developed countries and is facing the ire of regulators and health bodies globally.

The best approach to generating income from equities is to have a diverse portfolio. It is important to ensure that dividends are well covered and have the potential to grow since a growing dividend is likely to contribute to a rising share price in time. That sometimes means looking beyond the obvious areas of equity income and towards sectors where dividend growth has the potential to take off.

James Henderson is manager of the Henderson UK Equity Income Fund

Key points

GKN Aerospace has grown rapidly following the integration of Volvo Aero.

BAE Systems is viewed favourably by the US Department of Defense, which gives it a critical edge in winning orders.

Rolls-Royce recognised back in the 1990s that it would need to invest heavily in engine research.