Rolls-Royce – after the dividend cut

Back in mid October 2015 I penned a piece in which I posed the question of whether it was then better to buy the users of the engines that Rolls-Royce (I selected AIG to represent the airlines) made or Rolls-Royce itself. Its share price had by then already come down from 1,046p last May to 713p in October – a hefty twenty two per cent in about six months. I came to the conclusion at that stage that AIG was the better bet and made the great British engineer a hold. My analysis of the situation was primarily dictated by the fact that the accounts showed a picture of diminishing cash flow.

Even more unhelpfully, operating cash flow was in negative territory in the half year to June 30^th 2015. We had a situation where top line, annual revenue was holding up but net margins were falling in the headwinds of declining demand from mine and oil exploration customers for industrial turbines etc. Moreover, as I noted in July 2015, there seemed to be a deferral of Trent aero-engine orders for the awaited more efficient Trent 7000 engine. After no growth in earnings last year, the market is now consensually focussing on falling estimates for earnings – minus seventeen per cent in 2015 and minus nineteen per cent next year.

Annual results for 2015

The annual results, published last Friday, revealed and confirmed the company’s cash flow problem which obliged the new CEO to announce that the dividend payout was to be halved to preserve cash flow and the company’s important credit rating. The importance of this is underlined by the notion that large airline manufacturers and their airline customers might have been influenced to go elsewhere if they had doubts about the company’s finances when placing ‘mission critical’ engine orders.

Undoubtedly the company under its new chief executive has done the right thing for the business and its shareholders. It needs the cash to deal with what appears to be a passing restructuring problem and to restore its financial reputation. Interestingly, the share price rose like a rocket on the gloomy news, in a rally that was rooted in the relief that management was recognising and addressing its problems with a reorganisation and restructuring programme; hence the requirement for use of half the dividend money to help meet those costs.

Moreover, there was also a highly encouraging statement from the company in that it would return to more liberal dividend paying ways once the problems were fixed by the restructuring of the company’s operations; the share price reciprocated aerobaticlly, sending the share more than fourteen per cent higher to 606p. To put that into context, the Rolls-Royce (RR.) ordinary share price had dropped more than thirty one per cent over the preceding twelve months. In doing so, it had underperformed the FTSE100 Index by a relative twenty five per cent. However, in the last month, the share price has risen nine per cent whilst the market has dropped four per cent or so, meaning that the Rolls-Royce share price outperformed the market.

Last year, to December 31^st 2015, the company’s sales revenue fell one per cent to £13.4 billion pounds. The report and accounts prepared on a statutory basis misleadingly showed earnings up two hundred and fifteen per cent and pre tax profits up by one hundred and forty per cent. However, restating those results on a ‘like for like’ basis shows that earnings were down ten per cent and pre tax profits were down twelve per cent. Free cash flow fell some forty per cent to £179 million.

Civil aerospace

Cantering through the divisional operations, the critically important Civil aerospace business saw sales revenue increase three per cent and the order book rise by £3.8 billion. The divisional supply chain is being reformed to reduce costs and increase capacity in a ramp up of the production Trent and XWB engines. The engine business looked reassuring despite more recent market worries in that front.

Defence  

Revenue in the defence division was down five per cent because of weak helicopter and training equipment demand. Margins were down and there were restructuring and research and development costs. However, underlying profits rose by a reported four per cent 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 six hundred million dollars in its Indianapolis facility.

Power Systems

Power system saw revenue down four per cent. Although original equipment orders were lower, service demand was up. There were lower margins and underlying profits were fifteen per cent down. However, the outlook for 2016 was reported as positive; there was also a ‘healthy’ closing order book with long-term research and development helping to stimulate volume demand for engine applications.

Marine

Marine, which is relatively small, was the worst performer by far. Sales revenue fell sixteen per cent and underling profits slumped ninety four per cent. 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 be shown this year.

Nuclear

Underlying revenue was up nine per cent, 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, the company is cutting a swath through the top two levels of senior management as 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. Engineers do not go in for imagination but research and calculation – thank heavens. One would not wish to travel in aircraft powered by engines built with too much imagination and assumptions. (One dreads to think what kind of engines City analysts would build.) Engineers like to give themselves as much time as a job takes. So one can easily see that it is a culture that might respond slowly, albeit 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.

Where to from here? 

Very clearly the annual results and the statements about problems and their solutions have had an impact that has been lacking over the last year or so. The shares as a dividend payer are attractive and useful enough on an estimated consensus dividend of 16p for the year just begun; at 606p a share, last seen, that puts them on a prospective dividend yield of 2.6% – a useful payment in the context of the management’s commitment to rebuild the dividend when profits and cash flow permit.

The company’s problems seem less mysterious, and thus less disconcerting, now that the new management appear well dug into getting and conserving the cash to pay for restructuring the business – something which is already in train.  There seems no great problem with top line sales revenue but something is misfiring in recent management and operations; but this is a problem which the management has now identified and is correcting. Sales revenue was down only one per cent last year and the gross margin around twenty four per cent. Orders were also up. The lack of confidence in the management seems to have been addressed with this showing under the new man.

Technically, the share price chart shows a break from the downtrend. The share price could arguably trade sideways for a time somewhere between 550p and 750p. The business continues to look attractive from a long-term perspective.