LONDON (ShareCast) - JPMorgan Cazenove has initiated coverage of the European aerospace and defence sector, labelling Rolls-Royce, EADS and Thales as the stocks with the most share-price upside.

However, it's FTSE 100-listed power systems group Rolls-Royce (rated 'overweight') that is named as the "best-quality company in the sector", the US broker said in its morning note to clients on Tuesday.

Analyst David Perry said that this view was based on the firm's organic growth prospects over the next four to five years, its "best-in-class" RoCE (return on capital employed) and relatively low risk profile.

"We forecast RR to have an earnings per share compound annual growth rate of c13% from 2013-2016, driven by significant operational leverage (mainly in civil aerospace) and our view that RR will achieve significant cost reduction."

Elsewhere in the sector, JPMorgan has initiated coverage of UK group BAE Systems and Italian conglomerate Finmeccanica with 'neutral' ratings, saying that both companies face major structural problems and are likely to underperform peers over the next 12-24 months.

FTSE 250 defence suppliers Cobham, QinetiQ and Ultra Electronics are also rated 'neutral'.

Perry said: "We consider all three as high-quality companies but they are trading close to the top of their recent price-to-earnings range and the threat of sequestration in US defence provides near-term headline risks."

BC

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