The Investment Column: Rolls-Royce has the engine room to grow

BAT; AstraZeneca
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The Independent Online

Our view: Buy

Share price: 441.75p (+21.25p)

Investors applauded first-half results from Rolls-Royce yesterday which beat City forecasts for profits, cashflow and dividends. By the close of trading, shares in the world's second biggest aeroplane engine maker had advanced 5 per cent.

The group posted a 22 per cent increase in underlying pre-tax profit to £324m, boasted of having generated £122m of free cashflow (resulting in net cash of almost £460m on its balance sheet), and raised its interim dividend by 10 per cent to 3.67p a share. Thanks to improved efficiencies and productivity, Rolls-Royce was able to mitigate the impact of higher raw material costs and a weak US dollar. Key materials it uses include titanium and cobalt, both of which have soared in value amid strong demand from China.

There is now no doubt that Rolls-Royce's business model is working well, with rising new engine deliveries leading to increased top-line revenues. As the number of its engines in service increases, the group enjoys rising demand for its after-sales services - that is, vital maintenance work to make sure they are running as they should be. In fact, this activity accounts for 54 per cent of the group's revenues these days and is by far the most profitable.

Rolls competes with the likes of GE Aviation and Pratt & Whitney in the civil aviation market but is by no means dependent on the industry. It also sells into the defence, marine and energy sectors. Thanks to this broad portfolio, Rolls has been able to shrug off production delays to the new Airbus A380 superjumbo which it is supplying with its Trent 900 engine.

Going forward, the second half of the group's financial year should be just as buoyant as the first. Its order book now stands at £25bn and should swell further, while after-market sales are set to grow by more than 10 per cent for the remainder of 2006.

Several brokers upgraded their forecasts in the wake of yesterday's results. Given the momentum behind the business, further upgrades are very possible over the coming months. Buy.


Our view: Hold

Share price: 1,409p (-19p)

Smoking might be on the wane in Western Europe - because of advertising bans, health warnings and government curbs - but it seems to be having little impact on profits at British American Tobacco.

The owner of the Lucky Strike, Dunhill, Kent and Pall Mall brands has its geographical spread to thank for this. These days it is focused on pushing its cigarettes in emerging countries, where it promotes them as idealised Western goods. If yesterday's interim results are anything to go by, it is prospering from this strategy. Volumes in the Asia Pacific region increased by 5 per cent for the period, while in Latin America they rose by 4 per cent.

Underlying profits at BAT increased by 15 per cent to £1.39bn, although the company did warn that a part of this came because of favourable foreign exchange rates and the timing of certain shipments. This meant the world's second biggest cigarette maker was able to raise its interim dividend by 12 per cent to 15.7p per share.

With BAT now trading at 13 times forecast earnings for 2007, it is one of the cheapest stocks in the sector. Hold.


Our view: Take profits

Share price: 3,209p (-111p)

AstraZeneca has been one of the best performers in the FTSE 100 this year, partly because of persistent speculation that the Anglo-Swedish drug maker could be swallowed by GlaxoSmithKline or Switzerland's Novartis.

After suffering several setbacks in drug development last year, AZ has made some progress in replenishing its thin pipeline of new medicines by acquisitions and partnerships. Its chief executive David Brennan says he's not finished after a flurry of deals in recent months. The group splashed out £702m to take over Cambridge Antibody Technology, and formed a partnership with Abbott to develop a single pill version of Crestor, AZ's best-selling cholesterol drug.

Its existing portfolio of blockbuster drugs is certainly very strong and was behind yesterday's 26 per cent jump in second-quarter pre-tax profits to $2.2bn (£1.2bn).

Given the performance of AZ shares (they have soared 36 per cent in the past 12 months), investors would do well to take profits.