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Rolls-Royce still struggling

Full-year results from Rolls-Royce may have been better than first feared. But we expect more bad news to come, which is likely to send the shares back down
February 18, 2016

Value investors have patiently been waiting for Rolls-Royce's (RR.) downtrodden shares to bottom out. Judging by the reaction to the embattled engineer's results for the year to December 2015, many believe that moment has now arrived. But we remain concerned about profit and cash generation, and reckon these pressures aren't reflected in a premium valuation of 27 times 2016 forecast earnings, which means the recent share price fillip is likely to prove a suckers' rally.

IC TIP: Sell at 662p
Tip style
Sell
Risk rating
Medium
Timescale
Short Term
Bull points
  • Cost-cutting plans
  • Encouraging longer-term outlook for engine sales
Bear points
  • Dividend cut
  • Free cash flow weakness
  • Tough end markets
  • Operational dysfunction will take years to tidy up

In terms of the latest reported figures, a 12 per cent drop in constant-currency, underlying pre-tax profit hardly sounds like a recipe for the group's biggest share surge in 14 years. Neither does a halving of the dividend. But that, and the absence of a fresh profit warning following five in the last two years, more than satisfied an audience desperate for any cheer.

Rolls needs to preserve free cash flow, which is likely to come under fire from restructuring charges and a big investment cycle. That means the first dividend cut in 24 years was broadly welcomed. Clearly, investors were happy that this move could protect the long-term health of the business, and ecstatic that these extra funds seemed to rule out, for now at least, the possibility of a rights issue.

There was also a pledge to "rebuild over time" the payout to shareholders, although a gloomy outlook means that may take longer than many imagine. Better-than-expected free cash flow of £179m was boosted by a £58m intellectual property agreement, a one-off that's unlikely to be repeated in 2016. In fact, free cash flow guidance of a negative £100m to £300m was below brokers' expectations.

 

 

The intellectual property agreement wasn't the only one-off item to flatter Rolls' latest results. The income statement was boosted by a £189m long-term commercial aerospace contract accounting benefit, £40m from a defence contract variation and a £19m research and development tax credit for the nuclear arm. But in the absence of similar one-offs, this year could be much messier given the general deterioration in trading, increased costs in defence and nuclear operations, a restructuring charge of £75m-£100m, and an expected increase in the tax rate.

All the same, boss Warren East is sticking by his prediction of a 2016 operating profit hit of "just" £650m and expects to be able to cut £150m-£200m in annual costs from the business in coming years. But let's not forget the group's poor track record of setting targets in recent years, and the fact that conditions across all its end markets haven't improved since the last profit warning in November.

Management pencilled in small profit growth for Power Systems, an ambitious target for a business serving weak agriculture and mining markets. Equally concerning are the short-term headwinds weighing on the civil aerospace division, which accounts for about half of profit, due to dwindling appetite for dated Trent 700 engines, delays upgrading to more fuel-efficient models and weaker demand from emerging markets for corporate jets.

Even more troubling is the state of the aftersales servicing business, which is Rolls' main cash generator and the reason it sells new equipment for less than cash cost. As airlines start retiring existin engines to make way for new fuel-efficient models, this lucrative work is suffering. The impact of low oil prices on offshore exploration means the marine arm is weak; profit there nosedived by 94 per cent last year to £15m.

ROLLS-ROYCE (RR.)
ORD PRICE:662pMARKET VALUE:£12.2bn
TOUCH:661-662p12-MONTH HIGH:1,047pLOW: 497p
FORWARD DIVIDEND YIELD:1.9%FORWARD PE RATIO:23
NET ASSET VALUE:273p*NET DEBT:2%

Year to 31 DecTurnover (£bn)Pre-tax profit (£bn)**Earnings per share (p)**Dividend per share (p)
201314.61.7665.622.0
201413.91.6265.323.1
201513.41.4358.816.4
2016**12.80.6024.312.0
2017**13.30.7028.312.3
% change+4+17+16+3

Normal market size: 2,000

Matched bargain trading

Beta: 1.15

*Includes intangible assets of £4.6bn, or 253p a share

**Barclays forecasts, adjusted PTP and EPS figures