Rolls-Royce after the Bounce

Rolls-Royce at 688p on news of 350 operational staff hirings in the UK and plans for new Trent Engine test beds for the UK and Germany.

Rolls-Royce has a massive order book and has been investing in plant and people. In any event, everyone in the UK wants Rolls-Royce to succeed, from Thatcherite Tories to Labour trade unionists. The company can succeed without them but it is good to know that they are both rooting for the company. The stage now seems set for recovery, and the shares – market apart – look good value.

The share price journey of Rolls-Royce (RR.) has taken a lot of energy but not got very far; in fact rather like the troops of that Grand old Duke of York, up to the top of a hill and down again.

In the last episode of the Rolls-Royce share saga, the share price felt the bottom mud at between 500p and 600p, on publication of the 2015 annual figures. In this episode, it has advanced to 688p (last seen). The very lowest price for these shares was 497p last month, February 2016. Since then, it has risen about 40% to the ‘last seen’ price of 703p: an excellent recovery in a month or so.

The high point reached by the Rolls-Royce share price was around 1,200p in December 2013. In the following 25 months to February 2016, the share collapsed from there by 58%, to the aforementioned low in February, of 497p.

This dramatic fall was driven by a number of factors. First, the shares in December 2013 had risen steadily by 2.4 times to the peak at 1,200p – curiously, from a price level in 2011 that was pretty close to last February’s low. In other words, the shares have spent five years rising and then returning to the 2011 share price level again in 2016. Falling, from a great height is the very definition of dramatic tragedy.

Second, the peak share price at 1,200p made Rolls-Royce shares more than fully valued, thus tempting the market response promised by that old market truism about highly valued shares brooking no disappointment. At its peak of 1,200p the share Rolls-Royce share price was dear even in relation to its own trend. It was certainly highly rated in price to earnings terms, selling at 20 times the prospective earnings of 58.8p achieved in 2015 and 46 times the depressed earnings of 25.8p estimated for this year. As they say, hindsight is a perfect science.

Third, disappointment when it finally arrived came not as a single gulp but in spoonfuls, like the distasteful cod liver oil I was obliged to swallow, spoon after spoon, with seemingly no end in sight. The growing sense of uncertainty and worry prompted one successful City fund manager, who famously lost confidence and patience, to dump his entire holding near the bottom. That, it seems, was more a buy signal than a sell signal.

So what is the position now? The dividend action has been taken with future payments linked to future earnings: no more payment of dividends out of capital in advance of better, hoped for news ahead. Rolls-Royce has to that extent ceased to be a ‘dividend to worry about’ stock – or at least only partly so, depending on the outlook for future earnings.

Next, there is a new Chief Executive who has been free to take decisions and make declarations that his predecessor would have found difficult because of his implication in the problems. In fact Mr East has done well in bringing a perception of finality to what previously had been an open-ended worry. With the advantage that a qualified outsider invariably brings to internally created problems, he has, to the evident satisfaction of the market, demonstrated that management culture and structure were at the root of Rolls-Royce’s problems. In other words, its travails were not merely the result of external issues arising in the Marine division because of an oil-price driven collapse in external demand, but also the line management’s inadequate response to them. Mr East appears to have set about rectifying that in a convincing way. More importantly, from the market’s perspective, he also gave Rolls-Royce’s problems names.

So, how do things look now, after the partial but strong recovery in the share price? Looking at the company on a division by division basis, there are solid grounds for hope. Here I remind you of what the company told us on that score.

Civil aerospace: sales revenue actually rose 3% last year in this big crucial division and the order book rose by £3.8 billion. The divisional supply chain is being reformed to reduce costs and increase capacity in a ramp up of the production of Trent and XWB engines. The engine business looked reassuring despite more recent market worries in that front.

Defence: revenue in the military defence division was down 5% because of weak helicopter and training equipment demand. Margins were also lower and there were additional restructuring and research and development costs. However, underlying profits rose by a reported 4% and ‘steady progress’ was confirmed with equipment related to military transport and patrol seeing strong demand. The company expects long-term growth from its investment of $600 million in its Indianapolis facility.

Power Systems: this division saw revenue down 4%. Although original equipment orders were lower service demand was up. There were lower margins and underlying profits were down 15%. However, the outlook for 2016 was reported as positive; there was a ‘healthy’ closing order book with long-term research and development going in to stimulating volume demand for engine applications.

Marine: this relatively small division was the worst by far in terms of performance. Sales fell by a mammoth 16% and underling profits slumped 94%. Market conditions are described as still challenging with weak offshore drilling. There are plans for reducing resources and costs devoted to manufacturing as well as cutting back office costs. We are told the benefits of this will start to accrue this year.

Nuclear: underlying revenue was reported as being up 9%, led by relatively strong service revenue. There was increased submarine work and developing prospects in civil nuclear work. The outlook for the division was described as steady.

More generally, as reported, the new management is cutting a swath through the top two levels of senior management in a move towards changing the culture of the business. One has the impression that it has been slow-moving and hierarchical in structure and ethos. One can easily see that it is a culture which might easily respond slowly, if logically, to unforeseen problems. The new CEO is clearly changing that with more senior managers reporting directly to the CEO’s office on the progress that investors wish to see.

So what is an investor or interested investor to logically know? Do you buy these shares after such a big short-term rally or wait? Indeed, do you buy the shares at all after all the disappointment?

Dealing with the last question first, there are good reasons in principle for buying Rolls-Royce shares. Its business is internationally based. Its business is conducted in foreign currencies. That makes the shares, all other things being equal, a good Brexit hedge. The principal risk, as I see it, is market risk at this stage.

Looking at consensus forecasts, the current year to December 31^st 2016 seem to have everything, including the kitchen sink, flung in on the downside. The market consensus is for a known and understood 56% decline in earnings per share this year to an estimated 26p, putting the shares at 690p on a forward multiple of 27 times very depressed earnings. The thing that the market has been discounting in the share price for a year or so is estimated to happen this year. The estimated dividend yield for 2016 is a modest 1.9%.

Next year, the market consensus sees earnings recovering smartly and increasing by almost one third, putting these shares on an estimated forecast multiple at 690p a share (last seen) of 21.5 times recovering earnings with a dividend yield of a handy 2.3%. An estimated 33% growth in earnings for next year also makes the shares at 690p look good value in price to earnings growth (PEG) ratio terms.

In falling markets all shares seem to get marked down in the normal course of events. A marking down of Rolls-Royce shares from this level would represent an excellent buying opportunity.