Rolls Royce at 755p following the new CEO’s bearish comments

The shares “technically” may have some downside but they are now arguably good value, taking more things than one into account.

I had just turned down Old Broad Street past the City of London Club (once, most appropriately, the site of the ill fated South Sea Company of bubble fame) when I thought I heard a voice from a nearby alley. I looked and there was a geezer (the only way to describe him) with a long white face, under a crumpled Homburg hat from which protruded dark curls. There was a neat pencil moustache above moving lips that seemed to be whispering to me: “Oi, Guvner want to buy Rolls Royce cheap; a bit dented but basically in good nick!” He might have added: “You could go to yer own funeral in it” except that he was referring to Rolls Royce shares he had in cheap suitcase – not the magnificent car. I hasten to add that Rolls Royce long ago gave up manufacturing the motor. It is now aircraft engines and marine turbines.

The man in the crumpled Homburg had vanished when he saw an approaching City constable. Nevertheless, it prompted me to consider Rolls Royce share again; I note that I had last recommended them in February at 897p, before they rose powerfully and silently like a Silver Ghost engine, by 18 % to 1061p last May. Now after another profit and cash flow warning by the new CEO, on only his second day in the job, that there were still problems; or “head winds” as they like to call them. First, it appears that Trent civil aero engine orders are not coming through, as hoped. Second, the marine engine business seems to be still depresses by low but volatile crude oil prices, which having inexplicably risen in recent weeks, have now plunged again. There was also reference to a shortage of cash low with a discontinuation of the current share buy back programme, leaving the repurchases half way below this year’s original target.

The current share price (last seen) was 755p. It peaked just above 1,200p at the end of 2013, from where it has fallen by 36%. The current price takes the share back to levels last seen in 2012 but not back to the lower levels of 2010 – 2011 when the shares traded approximately, between 500p and 600p for some time. The share price chart does not strike me as having any obvious, strongly defined support above 600p. It looks as though, the share price is currently in no man’s land. The uncertainty concerning the company’s prospects have been chronic and served in wedding cake layers? I can well understand that no one wishes to rush in to buy it when markets are suddenly bearish.

The new CEO’s warning came when the world were trying to come to grips with the slippery problem of Greece, the EEC and the Euro; the stunning collapse of the Chinese equity market and some suspense about the outlook for the US. Not a great sellers market for Rolls Royce shares; or indeed, any shares very much at the moment.
We are also well past May and into the doldrums of summer markets, when volumes can thin out. Nor is it probable that the company might be taken over, because of its importance to UK defence which is protected by government’s controlling special share.

If you fail to answer the question, as in this case, of whether the shares are an immediate buy you should then ask the question, are they a sell? You will first take note that the Markit short selling indicator for Rolls Royce shares is low; inviting the view that they do not appear obviously dear; or more precisely, dear enough to drive them down with gloomy tales, for a predictable, good looking capital gain over the coming weeks. A bit of good news would obviously put them better; were it to materialise. It is not inconceivable that the company could do some corporate restructuring and sell off the currently uninspiring under-performing commercial businesses, raising cash and trimming up earnings estimates elsewhere.

Moreover, so far as the Trent engine is concerned, orders for the desirable Trent 700 engine seem to be lower, mainly because the buyers of hugely expensive civil aero engines would now prefer to wait a year or two, to order the much enhanced and more efficient Trent 7000 engine; with a name that no doubt incorrectly suggests it is ten times better. If there is ‘head wind’ competition challenging the Trent 700 orders, it is at least coming from the Rolls Royce Trent 7000; seemingly a case of demand delayed in the short term, rather than demand foregone in perpetuity. One cannot say that of the marine engine business; but as suggested earlier that could become the subject of corporate repair under the new, more investor friendly, CEO. Either he makes the case for brighter prospects ahead or he cuts the business.

In judging whether a share is worth buying you need to also include some estimate of its quality and sustainability Even if Rolls Royce makes only 59p of earnings this year, past growth in those earning since 2010 will have been 52% – or nearly 9% p.a average annual compound. Dividends have grown at around 7.5% p.a. on that basis.
The Rolls Royce business is capital and skilled labour intensive and so cash flow is obviously a problem when “chunky” sales revenue does not go, according to carefully calculated plan. It seems eminently sensible to me that the managers of the business in such times divert cash usage from share buybacks in such periods, to the fundamentals of the business; the manufacturing of ‘world class’ cutting edge, engineering. Moreover, it looks as though the company should have plenty of assets to borrow against, if need be, in the short term.

By market standards, a total debt to equity ratio of 35% looks restrained. It implies that borrowing powers are not stretched. The book value of net assets last year was a reported at 339p. That represents about 45% of the current share price. Knock that off the market price of 755p (last seen) and the estimated 59p of earnings for this year are valued at only 5.4 times against the market 14.5 times. Although the latest estimated market consensus may not factor in the new CEO’s comments, the estimated consensus dividend yield forecast for this year is shown at 2.86%. It is my personal opinion that Rolls Royce will not cut its dividend in panic. It has already cut the share buy back programme for this year and appears to have debt borrowing capacity for the short term, judging by the total debt equity ratio.

The shares were clearly over promoted and overpriced eighteen months ago. They are now beginning to look over sold. The shares may go lower, but they already look to be in good long term value territory. The temptation for institutional fund managers to average their book cost from here on is strong. These shares are good value in my judgment. I looked for the geezer with the Homburg, curls, pencil moustache and suit case but he had vanished.