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Rolls Royce Holdings plc - No new bad news

Steve Clayton | 12 February 2016 | A A A
Rolls Royce Holdings plc - No new bad news

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 102.80 | Buy: 102.95 | Change -0.35 (-0.34%)
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What Rolls Royce have said:

Ahead of their AGM today, Rolls has released a trading update that has caused the shares to tumble 5%. Whilst the company say they are on track to meet their targets for the year, the statement that the company is likely to be close to break-even in the first half, before finance charges, has unsettled the market. Such an outcome would leave the full year result wholly dependent on the second half performance.

Rolls Royce say that although market conditions in most businesses are now steady, 2016 will be a challenging year, as Rolls Royce continues sustained levels of investment, and transitions major Civil projects, at a time when Marine markets are weak.

On the bright side, FX movements are seen as a positive; current rates could add £450m to sales and £50m to profits, if sustained for the year. But cash flow has clearly not begun well, with some of the strong year end performance from 2015 reversing in January, to make the full year outcome very dependent on H2. Cost reduction plans though, are said to be well on track, with £30m-£50m expected for the year.

Our view:

Given the limited visibility over performance that Rolls Royce has demonstrated in recent years and the continuing difficult trading conditions being experienced by many companies in energy-related markets, a degree of nervousness was always likely to accompany such a statement.

The turn-around story at Rolls Royce is large and complex. New-ish CEO Warren East has a lot on his plate. But at the heart of it all there is a vast order book, over £75bn at year end, which , if Rolls can just get a grip on their cost base, ought to offer years of predictable work.

12 February 2016: Rolls Royce has announced full year results for 2015 which show no further deterioration from the conditions set out in their November profit warning. They have broadly reiterated their outlook for the business, across the major divisions. Having feared the worst, the market is clearly relieved that no new bad news has been delivered. The shares have bounced sharply, rising over 10% in early trading. Given the cash constraints the business faces, Rolls Royce have decided to reduce the annual dividend by half.

Underlying profits fell from £1,620m to £1,355m and revenues were down 1% to £13.4bn, both at constant currency. Civil aerospace profits fell 14% to £812m, Defence rose 4% to £393m, Power Systems slipped 15% to £194m, whilst Marine earnings collapsed 94% to just £15m. Nuclear earnings rose 40% to £70m. The order book grew 4% to £76.4bn, most of which relates to civil aerospace engines, especially the Trent XWB.

Profit headwinds for 2016 are still estimated at around £650m. These headwinds relate to margin squeezes in civil aerospace as older engines are retired and pricing for the Trent 700 is under pressure. The new Trent XWB engine, whilst selling well, has very little profit recognised on sale and it will take time for higher margin service revenues to build up. Corporate jet engines are expected to see reduced demand.

Defence is expected to have steady sales, but lower earnings due to the need to raise R&D to remain competitive when bidding for new work. Power Systems succeeded in winning new orders during 2015 to offset a weaker level of demand from oil and gas sector customers, which should support modest growth in 2016. Marine however, is expected to generate significant losses, reflecting the much greater impact of lower energy sector demand. Nuclear performance should be at similar levels of profit to 2015 with good longer term prospects.

Restructuring efforts are ongoing and the company hopes to generate cost savings of £145m p.a. by end 2017, with charges of £75-100m to be incurred in 2016, and more in 2017.

Outlook:

Group revenue in 2016 is expected to be marginally lower than in 2015, reflecting the pricing and volume effects seen in Civil Aerospace and the difficult trading conditions in Marine, with underlying profits still facing a £650m headwind. Rolls Royce remain confident of the longer term potential of the business to deliver growth.

Our view at 12 February 2016:

The name may say Rolls Royce, but lately, Rolls has looked and felt like a Lada. The November 2015 profit warning was bitterly disappointing, encompassing multiple divisions and market segments. Sharp deteriorations in the corporate jet markets, both new sales and aftermarket revenues, seem to have come from nowhere, whilst Rolls Royce appear to have fundamentally misjudged how their customers would manage the arrival of large numbers of new jets into their fleets.

Rolls Royce has a huge order book, but cannot translate this into reliable earnings at the moment. If new CEO Warren East can successfully restructure the business into a shape fit for purpose, there could be upside. But the concern must be that it will take so long that by the time it can be seen to have worked, the market for civil aerospace will have turned down.

The £650m profit headwind means that earnings in 2016 will be around half the level of 2015, with Rolls and its shareholders hoping for a recovery thereafter as cost savings kick in and the rising level of Civil Aerospace deliveries begins to outweigh the lower levels of income coming from older engines and the pricing pressure on remaining Trent 700 sales.

Rolls' key asset is the order book, which at £76.4bn offers substantial visibility of revenues, far into the future. But keeping the order book growing requires constant investment into new product development and Rolls say that this need, plus the investment in new manufacturing facilities, will mean that Civil Aerospace is a net cash consumer for several more years, having generated zero free cash in 2015.

Could Rolls Royce be vulnerable to a takeover approach? United Technologies, owner of Pratt & Whitney would surely be interested, for they are strong in engines for narrow body jets, whilst Rolls is strong in wide bodies. A combination would allow a lot of overlapping R&D to be cut. But the objections from regulators and airlines, about a major consolidation in a sector that is already oligopolistic makes such a move a long shot.

In the meantime, Rolls is at least now able to show no further deterioration in trading. It is too early to say that signs of recovery are visible, and it will be some time before service revenues on Trent XWB and Trent 7000 engines are significant. Rolls is unable to book much, if any profit on their initial sale. So like the journeys that Rolls Royce wide-body aero engines power, the stock is set to be a long haul.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.