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Rolls Royce: Not cheap or cheerful

Rolls Royce: Not cheap or cheerful
April 19, 2016
Rolls Royce: Not cheap or cheerful
672p

That prestigious position started to unravel in the past few years, as it gradually became clear that Rolls' business model and expensive cost base was no longer fit enough to tackle an increasingly challenging trading backdrop. Business got so bad that regular profit warnings became something of a tradition, an issue that was also blamed on management's poor target-setting methods. With trust at rock bottom, trading showing little sign of picking up and the British government threatening to intervene, even investors known for patience resorted to dumping big holdings at a loss.

This unfortunate scenario inevitably led a number of value hunters to circle the group's shares. For all the short-term uncertainty, the general consensus seems to be that this once great engineer will eventually reclaim its reputation for manufacturing excellence. Naturally, this type of thinking makes the opportunity to buy a stake when the valuation hits rock bottom a very tempting proposition.

Judging by the reaction to Rolls-Royce's full-year results in the year to December 2015, many believe that moment has now passed. The shares finished the day up 14 per cent, as reassuring words from management helped to restore some much-needed confidence. The biggest game changer was news that November's guidance for a halving of underlying pre-tax profit in 2016 hadn't changed. After five profit warnings in under two years, nervy investors feared these results would be accompanied with warning number six.

Even the decision to slash the final and 2016 half-year dividends by 50 per cent didn't seem to trouble investors. Rather than fret over the first cut in 24 years, markets were instead relieved that the new management team took active steps to protect the long-term health of the business without resorting to a dilutive rights issue. They were probably also won over by a pledge to rebuild the payout once the group's thirst for cash eases. But as the chart below shows, reaching previous levels may take longer than investors will hope for.

Importantly, this was the first set of results to bear the stamp of Warren East's early reign. The former boss of chip-maker Arm joined Rolls-Royce with a great reputation, only to face a quick succession of profit warnings as he struggled to deal with the aftermath of some of his predecessors' controversial decisions.

That Mr East immediately started his tenure by identifying the need to simplify the operations he inherited was undoubtedly well received. Even long-term stalwarts would agree that years of poor communication and high costs have undermined the business model.

A key example of this can be found in Rolls-Royce's civil aerospace operating margin, which continue to remain significantly below peers such as General Electric (US:GE) and Safran (Fr:SAF). While its rivals improved their manufacturing processes and benefit from economies of scale, Rolls' has been accused of living in the dark ages.

The new chief almost immediately started to touch the surface of these issues by outlining plans to streamline management and save up to £200m in the process. Further changes will be expected to follow, and perhaps even more now that activist investor ValueAct has finally convinced Rolls' bosses to give it a seat on the board.

Considering the extra funds required to keep its underfiring businesses competitive and the lower profitability of the key civil aftermarket, deeper cost-cutting certainly appears necessary, particularly as the mooted £200m-worth of savings will cost between £75m and £100m to implement. Even after factoring in the axing of the dividend and share buyback programme, it's hard to imagine these recent efforts being adequate enough to halt the pattern of plummeting free cash flow.

In the year to December 2015, free cash flow of £179m was flattered by a £58m one-off intellectual property agreement. Management accepted that this was an exception, before guiding for anywhere between minus £100m and £300m in 2016.

But Rolls' has a history of guiding for more than it can feasibly achieve. In 2014 the group switched guidance four times, in a series of blunders that sent the share price tumbling 31 per cent. Judging by the state of its core civil aerospace business, the damage could again be more severe than originally anticipated. As the chart below shows, analysts certainly seem to agree.

Nearly all of Rolls' Trent wide-body jet kit is sold with TotalCare service agreements, a process whereby engines are sold at little or no profit but tie the customer into long-term servicing and spares purchases. That makes maintenance contracts the group's big profit generator, which is a worrying scenario given the current state of the aerospace aftermarket.

Airlines are currently retiring their jets earlier than expected to make way for new, more fuel-efficient engines. What that effectively means is that there's now a distinct shortage of older kit to service. Unfortunately for Rolls, this trend looks likely to continue for quite some time yet.

Meanwhile, sales of Trent 700 engines have plummeted, while the transition to the next generation model required by today's planes has been plagued by costly delays. Add to this, evidence of slowing order books for Airbus (Fr:AIR) and Boeing (US:BA) following years of major aircraft purchases, and the outlook across this pivotal market becomes even murkier.

A slowdown in emerging economies also means Rolls-Royce's other businesses haven't been able to pick up the slack. That's been particularly visible in the Marine unit, which specialises in making engines and motors for offshore oil exploration. In short, the low oil price has suffocated offshore investment, a quandary that in the 2015 financial year saw divisional underlying profit nosedive 94 per cent to £15m.

Given this barrage of headwinds, we think markets have moved too quickly to call the bottom. While Mr East's immediate efforts to curb years of operational dysfunction should be applauded, the sweeping changes required to save Rolls from further embarrassment will take time to succeed.

In the meantime, a darkening outlook across all the group's end markets looks destined to continue weighing on cash and profit. That situation is likely to irk shareholders, many of whom are understandably growing increasingly impatient with the lack of progress on display. While a £70bn-plus order book looks good on paper, turning it into a profitable reality capable of spitting out cash represents a massive challenge for everyone from Mr East to ValueAct.

Those gloomy prospects make the shares, which trade at historical highs and an unusually huge premium to peers, look very expensive. A quick look above at falling consensus earnings forecasts helps to explain why significant sell-offs haven't yet translated into value.

Long-term buy-and-hold investors may take comfort in holding onto the shares through these years or turmoil. But we'd argue that those looking for a bargain would be better off waiting for a cheaper opportunity to arise.