A "rapid" deterioration in economic conditions and the impact of tighter Russian trade sanctions led Rolls-Royce (RR.) to issue its second profit warning of the year in an update that sent its shares plummeting 11.5 per cent at the end of last week. Despite previously predicting earnings growth in 2015, the engineering giant announced that underlying profit next year would fall up to 3 per cent because a deteriorating market had caused customers in energy and mining industries to cancel or defer contracts.
Rolls confirmed that group underlying revenue for 2014 would be between 3.5 per cent and 4 per cent lower than the flat rate expected. Furthermore, free cash flow is expected to drop 55 per cent from the previous guidance of £780m to about £350m, in spite of accelerated cost-cutting.
In February Rolls issued its first profit warning in a decade, citing cuts in defence spending by western governments as the main cause behind flat underlying revenue and profit. But in July it pledged a return to growth in 2015, yet the company's power systems business, which makes engines for marine and mining equipment, and its small nuclear and energy division, which manufactures gas turbines, has since suffered significant headwinds.
Chief executive John Rishton, who faces the task of rebuilding investor confidence after a series of disappointments, said the fall in the oil price, the drop in value of iron ore and slowdowns in Chinese and eurozone economies is weighing heavily on the group's building, energy and mining segments. What's more, although Rolls' direct sales into Russia are limited, he warned that increasing trade sanctions meant clients with exposure to Russia were now buying less.
There has been a spate of high-profile profit warnings this year, with UK engineers in particular falling victim to weak share price performance and a significant sector-wide derating. And with the IMS season now in motion, Rolls may be the first of many of its peers to blame macroeconomic turbulence for sparking further profit cuts.
While not many UK aerospace, defence and engineering companies have massive direct exposure to Russian markets, they, like Rolls, look likely to be damaged by the impact the sanctions have on its many trade partners. For example, trade restrictions have been blamed for the recent slowdown of output in Germany, where Rolls-Royce's Power Systems is based, and which has pushed Europe to the cusp of a triple-dip recession.
Mondi (MNDI) last week warned that third-quarter operating profit fell 10 per cent from the previous quarter, and it has already spoken of the impact of falling European demand, while box maker DS Smith (SMDS) will also likely pay for making two-thirds of its profits in the eurozone.
Recent economic weakness in Asia has also led to an aura of caution for a sector with plenty of international exposure. Prospects for the likes of radio frequency, microwave and semiconductor expert e2v Technologies (E2V) and precision engineer Renishaw (RSW) are bleaker now that their key growth market has entered a period of lower growth and general uncertainty.
Furthermore, Rolls is not the only engineer to have exposure to anaemic mining and energy markets. Molten metal-flow engineer Vesuvius (VSVS) and conveyor belting and polymer products group Fenner (FENR) have both been punished for their exposure to mining, while recent news that the price of oil slumped to a four-year low could prompt yet more profit warnings. Engineer Rotork (ROR) gets 59 per cent of group sales from oil-related activity, while pump manufacturer Weir (WEIR) could lose out on much needed shale gas revenues.
