Rolls-Royce shares at 513p following the trading statement. The explanation of the latest downgrade (they come in threes like buses) is still a bit obscure and needs further explanation. However, I feel the shares are good value longer term and once the short term mists have lifted, will be an appropriate addition to a long term investment portfolio. The report and accounts are due at the end of this month. Hopefully, they will be more revealing than the trading statement which feeds rather than resolves uncertainty.
Last October, in a somewhat idiosyncratic frame of mind, I compared and contrasted the shares of Rolls-Royce (RR.) as a supplier of civil aero engines (and other types as well, of course) and International Consolidated Airlines (IAG) as a user and buyer of such engines. Although recognising the sheer quality and long term growth prospects of Rolls-Royce as evidenced by its huge order book, I came to the conclusion that one should chase IAG but not Rolls-Royce. The latter had lost nothing of its quality for scarce, precision, world leading aviation engineering but its evidently shorter term problems had dented the company’s near term prospects along with the share price. (In the last month Rolls-Royce has fallen by about 25% whilst IAG are pretty much the same price.)
Back then, I felt that the share price was too low for its long established track record and long term prospects (as reflected in the massive order book) as one of a few and rare global aero engineering companies (as evidenced by its recent high gross profit margins) which enjoyed equally rare and high barriers to entry. However, I concluded that the share price could get even lower; which it has – having reached 520p Friday 13th November following the trading statement for the third quarter of this year to September 30th. That is now almost half the peak share price of 1,046p last May. A price now so low that the shares are selling 2% less than they were five years ago.
This Neanderthal cave dweller’s caution seems to have served him well on this occasion, to judge from the latest profits warning from Rolls-Royce and the reaction of the share price to the downbeat news from the company. The market was startled by it, as seen from the immediate 20% collapse in the share price – another example of the imperfections of allegedly perfect share markets.
When from time to time, reviewing the affairs of Britain’s last great survivor from its vanished, not long ago great age of engineering supremacy, I have routinely checked the Markit short selling indicator and always found it to be indicating only low levels of short selling. Few of us, it seems, believed that the problems confronting Rolls-Royce were more than temporary. But now, in November 2015, they continue to persist and indeed seem to be getting worse in terms of forecasts, estimates and expectations. The pertinent question remains are the shares ready for buying – and if not should they be traded out of a portfolio?
The Management Statement
The statement from the company gave the market and shareholders a changed outlook for prospects for this year as well as next year to December 2016. This year’s guidance remains the same but we are advised to expect results to be at the lower end of indicated performance, not the higher.
For next year, we are warned of ‘sharply weaker’ demand, including that of the aftermarket engineering services for wide bodied airliners, the corporate market, the regional aerospace market and the offshore marine market. That seems to boil down profit estimates by a further £300 million. That is plain enough, but the explanation is more complex and somewhat obscure. This shrinkage in profit expectations is due to ‘modest’ unbudgeted reductions in revenue in relation to the company’s high fixed costs. The good news is that this largely affects profits, not cash flow.
Future cash flow and dividends
This is reassuring because cash flow is real whereas profits are the product of accounting conventions. It is good also because Rolls-Royce last year had a significant drop in operating cash flow which continued to be seen in the June accounts. It no doubt for that reason that the company has announced that the dividend policy will be reviewed by the board to see if changes, ‘if any’, are required.
In the third quarter to September, volume demand for corporate jets powered by Rolls-Royce engines fell ‘sharply’. There was also more weakness in the demand for corporate jet after market services, and a ‘significant’ drop in aftercare services for jets serving regional airline schedules. The good news is that demand for wide-bodied engines remains good and unchanged with prospects of an increased market share of that market where the company competes on increasing technical advances including such things as thrust, fuel efficiency etc.
The problem is that as more efficient aircraft come into service, they appear to reduce demand for overall aftercare services. There also seem to be some accounting implications for reported profits dependent on whether new aircraft engine contracts have linked aftercare services contracts. As stated, the cash flow seems OK but profits appear to be delayed. It is partly esoteric accounting by the sound of it but also partly economics because the relatively new CEO laments the fact that the company has not managed spare capacity. In that context, he goes on to complain that the company generates lots of data but not enough information. This sounds like the complaint of a chief executive officer who may not be getting enough information to enable him to steer the ship from shallow waters. If so, it is a cultural problem which as such, is within the power of the company to reform.
The report and accounts for the third quarter are due in the last week of this month. One hopes that they will help to clarify the cash and dividend position. They should, because dividend uncertainty will almost certainly undermine the shares.
Meanwhile the market will probably do little until the nine month report and accounts come out at the end of the month. The latest consensus earnings forecasts I have seen, are for a 17% drop in earnings this year and a 20% decline next year. That puts estimated earnings next year at 43p and at a share price of 513p (last seen) on a prospective estimated price to earnings ratio of 16 times. The company traditionally only pays out about a third of earnings as dividends, which is something it did last year and the year before. If it is thinking of returning to that arrangement then estimated forecast earnings of 43p for next year suggest a dividend payout of 14.3p or about 2.8% on a share price of 503p.
There is also the fact that after-sale service margins may be reviewed by EEC authorities. News of that is also needed to make a judgement about the future.
My own view is that these shares look good value long term and it is very much a question of working out when to step aboard as a long term investor. I add, for what it is worth, that a five year share price chart shows the current share price to be on what looks like a long term trend support level. That is not in itself a reason to buy the shares; but it does seem further reason for regard them as cheap and looking for the best point at which to buy them. I think that we are close to that point now. However, I shall await the next report and accounts at the end of this month to help clarify things.