Tuesday, 24 November 2015

Rolls Royce - as we were

Just over ten days ago I wrote an article on the struggling (five profit warnings in 18 months) industrial concern Rolls Royce observing:

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. 
No surprises that today's 'Group update' did not provide a definitive 'this is what we are doing' update.  More numbers and words on the plan/progress will be forthcoming at another capital markets day in six months or so.  The chairman set the tone with early observations including:

‘under no illusions’

‘we get it’

‘improvement in our financial and operational performance’

‘improve our internal controls…communication…absolute priority’

‘long term this is a growth story’ 

As for the core of the presentation from the newish CEO Warren East (formerly CEO of UK tech high flyer ARM Holdings) he said all the right things noting that over 80% of the business was in 'attractive growth markets'.  

Of course disproportionately this is focused on the widebody aircraft engine business where investors have hoped for this...


...but via a combination of poor company communication and the inevitable issues with lumpy businesses with 15-40 year cash flows (noted by the CEO akin to some of the charts shown in ARM presentations!)... 

...there has been too much surprise at patchy cashflows following new product introduction supplemented of course by those cyclical lumpy factors that have impacted the other divisions (marine, defence, business jets).  

To horribly summarise the presentation reiterated need to communicate effectively the sheer potential of the whole portfolio...as shown by the heightened cash flow of a matured widebody business (a further - and even more impressive implied cash flow chart - was shown for the 10 year period).  

Of course you cannot just hang around and wait for the cashflows. As the activist shareholder has noted refining the cost case is kind of sensible too.  There were not too many answers here - they will follow next year - but clearly you should anticipate much if any of a dividend as they transition.  

Yes the shares bounced (+3%) as there was nothing newly dire here but there is still everything to play for.  Stay in for the long term or don't invest at all.

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