Rolls-Royce issues another profit warning

Boat © Rolls-Royce
Rolls-Royce: locked in a downward spiral?

This week FTSE 100 engineering giant Rolls-Royce (LSE: RRissued its fourth profit warning in less than 18 months, and halted its half-finished £1bn share buyback programme, just days after new chief executive Warren East took the helm. The company had expected to make £1.4bn-£1.55bn profit in 2015, but it cut its expectations to £1.325bn-£1.475bn.

Low oil prices have hit demand for vessels and rig equipment from its marine division, as oil explorers cut back on investment. The civil aviation unit – its largest revenue generator – has also been an issue, says Kamal Ahmed on the BBC. The development of the new Trent 7000 jet engine has hit orders for the old model, as customers hold off for the new version. The share price fell by 6% during the day, and by as much as 10% at one point.

There’s nothing unusual about a new CEO taking the opportunity to “clean out the stables”, says Peggy Hollinger in the Financial Times. What rattled investors is that this doesn’t seem to be what East was doing. This latest warning comes off the back of the “hastily declared findings” of a financial review that started before he arrived. As a result, investors don’t know what to expect when East completes his own review.

Some analysts are even speculating that the door is open to a fifth profit warning. East acknowledged that there have been “weaknesses in how the business compiles its forecasts”, says The Guardian’s Sean Farrell. But he also argues that the decision to release the results of the review now shows that Rolls-Royce is “reporting its problems earlier and more clearly than previously”. That may be so, and the problems at the marine unit are only to be expected, says the Lex column in the Financial Times. Most oil and gas services firms have had “a rotten year”.

But the problems in the aerospace division are more worrying. This is Rolls-Royce’s core business – it’s “what engine makers do”. Yet it “is having trouble predicting how that process will go”.

Our view

Rolls is currently trading at 14.3 times 2016 earnings, which looks aggressive, given the potential for another disappointing business review. Beyond the civil aerospace problems, defence budget cuts are expected to continue around the world as governments tighten their belts and focus on cybersecurity.

And while there is a lot of upside if East manages to turn the company around, we’re not optimistic, given that he was previously a non-executive director in the company. So we’d pass for now until there’s more clarity, or the valuation falls further. Overall, there are more attractive options out there.