Rolls almost rocking

The aerospace industry took a hammering in 2009 as hard-pressed customers cancelled hard-won orders. Against that backdrop, Rolls-Royce had a reasonably satisfying year as the engine maker managed to hold off the worst of aerospace downturn.

Indeed, shares in Rolls should be a solid addition to most equity portfolios in the coming years, assuming the UK's manufacturing sector gets a lift from future governments and getting the financing to buy aircraft continues to become easier. That should leave hi-tech companies with a solid brand and strong exports, such as Rolls, in a good position. Rolls certainly has the track record to foster confidence. Since reaching a low point in 2002, its share value has quadrupled as the business returned to year-on-year growth.

It helps that the outlook for the aerospace industry is improving. Boeing's 787 Dreamliner finally took flight in December, powered by Rolls-Royce's Trent 1000 engine. If the production issues that have plagued both Boeing's and Airbus's major projects are finally sorted out early next year, then orders for engines and aircraft components could start to recover.

In addition, finance to buy aircraft seems to be easier to obtain and sector watchers point to United Airlines' recent deal to acquire 50 Boeings as a sign that airlines are slightly more confident about the future. Indeed, IATA, the International Air Travel Association, now forecasts that worldwide losses for airlines in 2010 will be in the region of $5.6bn (£3.4bn). That might sound grim, but it's just half of 2009's miserable total.

While cheap credit helped to inflate a bubble in aircraft sales, at least Rolls avoided the mistake of becoming too dependent on engine sales during the good times. Instead, the company used the time and the financial windfall to develop its after-sales servicing and parts business, which has proved resilient in the current downturn. So resilient, in fact, that analysts at stockbroker Investec forecast that Rolls's underlying profits during the current aviation slump will take only a 2 per cent smack, compared with a 57 per cent blow after the 2001 crash. That justifies the focus on parts and servicing, especially as this side of Rolls's operation offers fat profit margins and a predictable - and even growing - income stream as ageing aircraft engines need more maintenance.

Diversity alone doesn't mean much in a tough environment without hard cash. Happily, Rolls had net cash of just over £1bn at the end of June and analysts think this balance will rise modestly in 2010. In addition, sterling's weakness may also help profits as most of Rolls's sales are invoiced in dollars. That said, it has covered its exchange-rate exposure with currency hedges for at least the next six years. In the meantime, cost-cutting will also play a role and management has already reduced the size of the work force to 40,000 in the face of the recession. Analysts think this will generate savings of £175m in 2010.

There are, of course, risks to investing in Rolls shares. While diversification has helped the group, it is still dependent on civil aerospace for just under half its sales and lingering weakness or sluggish growth in the sector will depress Rolls's profits over the long term. Also, a lot rides on whether the next UK government is serious about rebalancing the economy in favour of manufacturers and exporters.