If there’s one thing the City hates, it’s disappointment. The price of a company’s shares is based on expectations of what future profits will be. So if a share price is to stay high and rising, profits have to do the same – or at least promise to do the same. You can’t disappoint people.
That’s why Rolls-Royce has taken a beating this morning. It’s fallen foul of the City expectations machine. Despite posting very good financial results for 2013 with profits growth of 23%, it has said that profits won’t grow at all in 2014. The share price has been hammered.
I tipped Rolls Royce as a long-term buy in MoneyWeek magazine a few weeks ago. While the timing of this tip now looks unfortunate, I still believe the long-term prospects for its shares look good.
Profits will be held back in 2014 because governments are cutting back on defence spending. As a result, Rolls-Royce expects profits at its defence unit to drop by 20%. That’s disappointing. But the investment case for Rolls Royce has always been primarily about the the company’s civil aerospace business, as customers such as Boeing and Airbus ramp up production. Profits here in 2014 are expected to grow strongly, and total company profits are expected to start growing again in 2015.
Taking a step back from the short-term outlook, Rolls-Royce is in rude health. Its order book of £71bn equates to nearly five times its current sales. This will help to deliver long-term profit growth. It can also still do a lot to help itself by cutting costs and boosting cash flow. The company also has £1.9bn net cash in the bank.
Rolls-Royce still has the potential to build and grow a very valuable income stream as more engine deliveries create a more lucrative aftermarket business. It will just take a little longer for the benefits to come through. If the business was permanently damaged by this warning, then there would be legitimate grounds for concern.
But I don’t think it’s time to panic. No-one likes setbacks, but they can be good for patient investors. This is not the time to sell Rolls-Royce – in fact, it’s time to take advantage of the fact that the shares – at 1,025p – are 15% cheaper than they were yesterday. Buy.