A Game-Changing “Green” Trend is Good News for this Best-in-Class Company

Spurred by the Obama administration and public pressure around the world, this industry will have to change — and fast. New environmental regulations are emerging from Washington and Europe that are compelling the industry to change its ways and play a bigger role in the fight against global warming.

The stakes couldn’t be bigger: the industry accounts for a growing amount of pollution. If it fails to act, these companies could very well emerge as the next environmental villains.

The industry? Aviation. Political sentiment is mounting, not only for the industry to slash its greenhouse gas emissions, but also its noise levels. But there’s good news for investors. One beneficiary of the push for “greener” aviation, Rolls-Royce (LSE: RR.L), looks set to capitalize on this trend.

Britain-based Rolls-Royce, the world’s second-largest maker of aircraft engines behind General Electric (NYSE: GE), split from the famous luxury car maker of the same name in 1973. The company makes engines for military and civilian aircraft and has done more than any other aerospace engine maker to step up to the plate and meet the green challenge.

Rolls-Royce’s group sales break down accordingly: defense aerospace — 21%, civil aerospace — 53%, marine– 17%, and energy– 8%. The company is listed on the London Stock Exchange and is a component of the FTSE 100 Index (be sure to check with your broker before buying shares).

The trends in favor of green aviation are clear. Air traffic increasingly congests and pollutes the skies, and the Federal Aviation Administration (FAA) projects the number of U.S. airline passengers will nearly double from about 740 million this year to 1.4 billion in 2025. Air traffic controllers are expected to handle 95 million flights of all types of aircraft in 2025, compared with roughly 64 million today.

#-ad_banner-#Renewed growth in the aviation sector worldwide, especially in the still-expanding economies of India, China and Russia, generates new airlines and large orders for new aircraft. China alone has 40 new airports on the drawing board.

Experts project that by 2050, aircraft emissions will become one of the largest contributors to global warming. Carbon dioxide (CO2) emissions from human activity now account for more than 84% of all U.S. greenhouse emissions. Transportation (which includes aviation) is the biggest CO2 culprit, at 33%.

Engine researchers in Europe and the United States are focusing on next-generation technology to propel aircraft, but Rolls-Royce is a step ahead of the game. The Rolls-Royce Trent 1000 turbofan engine, which powers the composite-built Boeing (NYSE: BA) 787 airliner, already boasts advances in environmental-friendly innovations.

In addition to being the launch engine for the 787, a huge and strategically important end user, the Trent has been phenomenally successful throughout the aviation industry. It also powers the A380 and A350, widely flown airliners built by Boeing’s archrival Airbus, and a host of other popular aircraft. The Trent 1000 commands a 40% overall share in its markets.

Rolls-Royce has refined the turbofan process to reduce the emissions as well as noise. The Trent 1000 is the most fuel-efficient engine ever produced by Rolls-Royce or its competitors. It has cruising fuel consumption up to 15% lower than the company’s previous generation of turbofans. It’s also quieter.

Rolls-Royce’s competitors also produce greener aircraft engines, but Rolls-Royce is the purest play on the green aircraft engine trend. General Electric and Pratt & Whitney offer innovative engine products, but GE is a vast conglomerate with fingers in many pies and Pratt & Whitney is a subsidiary of another diversified conglomerate, United Technologies (NYSE: UTX).

Rolls-Royce has signed onto to a set of goals set by the Advisory Council for Aeronautics Research in Europe (ACARE), an organization with about 40 members, including government agencies and private companies. ACARE calls for the following achievements by 2020:

  • -50% reduction in fuel burn and carbon dioxide (CO2) emissions per passenger kilometer;
  • -80% reduction in nitrous oxide (NOx); and
  • -50% reduction in the perceived external noise level.

That puts Rolls-Royce in the forefront of eco-friendly engine manufacturing. And yet, Rolls-Royce’s stock is off -10% from its 2009 year-end peak. Its P/E of about five represents the market’s severe undervaluation of this stock and is an overreaction to the aviation’s woes during the recession in 2009, which is now substantially easing.

Consider this: Despite the severe slump in aerospace last year, Rolls-Royce posted a +4% annual increase in 2009 pretax profit to 915 million English pounds, on sales +14% higher at 10.4 billion. Rolls-Royce’s stock looks set to rise on the strength of the industry’s much rosier prospects, combined with the inexorable push toward green aircraft engines.