By Chris Bailey of Financial Orbit | Thursday 12 November 2015
Disclosure: I own shares in one or more of the stocks mentioned. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from ShareProphets). I have no business relationship with any company whose stock is mentioned in this article.
In the Thursday earnings season results frenzy I knew that Rolls Royce’s (RR/) interim management statement was going to be of the ‘excitable’ nature when the first emboldened headline of the statement was ‘fundamentally strong portfolio of products’.
Experienced market observers know that such a statement is going to be followed by some kind of ‘BUT’…
And so it was. I have actually lost count of the number of companies in the defence and aerospace sectors that have aggressively grumbled over market conditions during the last few weeks. Maybe it should come as no surprise that Rolls Royce should join them noting ‘sharply weaker demand in 2016, including in wide-bodied aftermarket, corporate and regional aerospace markets and offshore marine’. And the profit headwinds for 2016? A cool £650m. Even with a new near £200m of benefit cost cutting programme that is a serious blow for a company who previously had guided to around £1.4bn worth of underlying profits. No wonder the shares are down 18% to under 550p as I write.
Back in July (link here) I wondered if Rolls Royce was the new BG Group (BG) where multiple downgrades and profit warnings was followed by an opportunistic bid from a large sector peer. Even if the UK government’s golden share complicates matters, with the current market cap of £10bn halved from the level of two years ago any underlying interest out there should be piqued.
However you cannot invest on such rationales alone – in fact I would factor it into only 10% of your thinking: the other 90% requires long cycle versus short cycle analysis.
Rolls Royce is possibly the most long cycle centric business in the FTSE 100 today because the service level provision on for example an aircraft engine over its multi-year (usually multi-decade) life has a much bigger impact on profits than the initial unit sale. Therefore looking at the statement today the more worrying impact is not a slowdown in the corporate jet market but the observation of ‘reduced utilisation by some specific operators of older wide-bodied engines’. Mix shorter term macro with some attack on some of those longer term services revenues and it is not a happy combination even if their current market shares are holding up reflecting inherently a good core aerospace engine product (and hence ultimately good enough services revenues).
The still newish management – led by Warren East formerly a highly successful CEO at ARM (ARM) – are disappointingly still grappling with the figures. Today’s statement reflects the knowledge that there was a profits and guidance gap and using their last capability to ‘kitchen sink’ the numbers before they have…or at least teed it up for a further update on the operating review on 24 November and the full year numbers in February.
Yes, there are no numbers for 2016, medium-term services revenues/profit guidance or comment on the sustainability of the dividend, buyback or even the current credit rating. You can understand why investors have every reason to conclude they should leave this one alone.
Two final thoughts however. First remember that a few months ago ValueAct - the US hedge fund has become Rolls-Royce's biggest shareholder believing there is a significant cost cutting opportunity, an observation that the newish management are seemingly starting to share.
Second the company’s balance sheet is not dire. It is certainly complex – including multiple currency hedges – but not dire. My rough back of the envelope calculation puts the company in 2017 when cost and other challenges work through at around a x10 EV/ebit multiple with clear scope for a 5%+ free cash flow yield. In normal times that would be value – and if you were a long cycle investor focusing on services revenues that is what you should conclude. However for anyone with less than a couple of years plus timescale this is not a share for you. Lumpy short cycle sales markets are giving you no visibility.
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