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Rolls-Royce shares up 10% as further deterioration avoided

George Salmon | 28 July 2016 | A A A
Rolls-Royce shares up 10% as further deterioration avoided

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 104.46 | Buy: 104.56 | Change -2.44 (-2.28%)
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Rolls-Royce shares were up 10% this morning after the company released first half results that confirmed that the group is trading in line with its most recent guidance.

Highlights (with figures quoted on an underlying basis at constant exchange rates):

  • Revenue fell by 5%, led down by a 25% drop in Marine revenue, and a 5% fall in Civil Aerospace, the group's largest division by revenue. These sectors were both impacted by reductions in original equipment and aftermarket services revenues.
  • Defence, Aerospace and Power Systems saw revenue declines of 1-3%, while Nuclear, the group's smallest division by sales, was able to report an increase of 14% in underlying revenues.
  • The group's long-term order book is now valued at £79.5bn, which is up 4% from the end of last year. New orders included a $2.7bn order from Norwegian for Trent 1000 engines.
  • Profit before tax is £104m, down 80% in line with previously communicated declines in Civil Aerospace trading. Although cash outflows were better than expected, at-£399m, this is mostly impacted by timing of cash reconciliations. In line with the cash outflow and shareholder payments, group net debt increased to £712m from £111m.
  • If current exchange rates prevail through the year, underlying revenues and profits would be positively impacted by around £600m and £60m, respectively.
  • The group's cost savings plans are progressing, with a £50m benefit expected this year, and around £150-200m by the end of 2017. The outlook for the year remains unchanged. Bloomberg consensus has earnings per share at around 26.4p for the year, down from 58.7p last year.

CEO Warren East said that "the business has made some positive first steps on the journey that will lead Rolls-Royce to profitable and highly cash generative growth, including introducing more pace and simplicity to the company."

Our view

A series of five profit warnings in the 20 months up to November 2015 has seen Rolls Royce stall repeatedly.

The profit warnings generated by a falling oil price and a decline in defence spending may not have been entirely palatable, but many investors will have been more understanding of these than the warning generated by a fundamental misjudgement of the potential for 'aftermarket revenues'. This essentially meant that Rolls-Royce lost revenues as potential customers chose to retire old planes rather than have them serviced. Many airlines have instead elected to replace older planes with a new generation of more fuel-efficient models.

At the time of the fifth profit warning, in November 2015, Rolls' credibility had taken a battering and new CEO Warren East must have been wondering what he had got himself into. Since then, the shares have recovered somewhat. Given its large UK cost base (23,200 of their 50,500 employees are based here) and high proportion of overseas revenues, Rolls has received a boost recently from the weaker pound.

Mr East's plans focus on making Rolls run smoothly again by increasing the pace and simplicity of their operations. In seeking consolidation, he has pressed ahead with a €720m acquisition of ITP, the Spanish company it already had a large stake in. This should boost the group's aftermarkets revenues.

At present, Rolls' key asset is the order book, which at £79.5bn offers substantial visibility of revenues, far into the future. But keeping the order book growing requires constant investment into new product development. Rolls say that this need, plus the investment in new manufacturing facilities, will mean that cash flow is likely to remain under pressure in the near-term.

After a cut to the dividend, this pressure is likely to result in minimal increases in the next couple of years, despite Rolls targeting a progressive restoration towards a more 'appropriate level' . At present, the shares trade on a prospective yield of around 1.6%.

We feel that Mr East is taking steps in the right direction, however the road ahead could well be a long one.

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.