A spot of engine trouble for Rolls-Royce

Profits are down at Rolls-Royce and the shares have crashed but the engine maker is probablyon the flight path to recovery, says Simon Wilson.

What has happened?

Engine-maker Rolls-Royce (not to be confused with the smart car maker from which they split more than four decades ago) last week shattered its decades-old reputation for solid, profitable growth by issuing its fifth profit warning in 20 months and putting shareholders on notice of a possible dividend cut. The news on profits was bad enough: they would be around £400m lower than anticipated (at around £800m, think analysts) due to stronger top-line "headwinds" (that is, lower revenues) than expected.

But the market was just as spooked by the dividend cut: Rolls-Royce hasn't taken such a measure since 1992, and even the possibility marks a rather astonishing turnaround since earlier this year, when under previous boss John Rishton it was still planning a £1bn share buyback. All this turbulence and fears of more to come sent shares crashing 20% in a day, down to 536.5p. That makes a total slide of around 50% this year.

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What's been going wrong?

The chief executive, Warren East, the former head of chip-maker Arm who took the helm at Rolls in July, says the group has taken a hit from slack demand in the third quarter in three core areas: the servicing of engines on older, wide-body passenger jets; the offshore marine market (which has been hit by the lower oil price); and business and regional jets (where Rolls has lost out to rivals). The crucial factor is the first.

Rolls-Royce is famed as a manufacturer of quality engines, yet half of the business's revenue comes from highly profitable service and maintenance contracts, with most of that accounted for by bigger turbines for long-haul jets. In recent months that revenue stream has been hit hard by big airlines deciding to retire older aircraft earlier than expected and in bigger numbers.

How are its rivals doing?

As yet, there's no sign of the market weakness identified by Rolls hitting its chief rivals. United Technologies, US owner of the Pratt & Whitney engine business, reaffirmed healthy profit projections when it announced its own Q3 results last month, while General Electric reported "another robust quarter". Both have higher margins than Rolls.

Rolls-Royce has had some "bad luck", reckons analyst Richard Aboulafia of Teal Group. A key customer, Canadian aircraft and train maker Bombardier, has run into trouble with some of its jet programmes. And Rolls is also suffering reduced demand for G450 and G550 business jets made by Gulfstream, having lost out to Pratt on supplying turbines for the new models. But alongside the bad luck, there's also been some "bad strategy".

What are the strategic issues?

One key issue is that during the past decade of rapid growth, Rolls failed to tackle its high fixed-cost base. But the main issue may simply be that Rolls is focused on less attractive areas of the market than GE and Pratt. First, it abandoned a joint venture with Pratt, missing out on the boom in narrow-body passenger jet engines. And second, argues Peggy Hollinger in the Financial Times, the Derby-based firm's diversification into marine engines has taken attention and resources away from the critical structural issues facing Rolls's core aerospace business.

What are the solutions?

East has made clear that he faces a long-term challenge. To start, he has promised to cut costs by up to £200m from 2017, on top of an already-announced £115m reduction, in an effort to boost profitability. He also plans to streamline senior management and focus on bringing "greater pace and accountability to decision-making" improving management information, forecasting and business systems. East is convinced that Rolls needs some diversification to balance its reliance on engines, so analysts say it is unlikely that he will bow to the demands most notably from US activist investor ValueAct, which has a 5.4% stake to sell off the marine propulsion unit.

Is Rolls-Royce doomed?

Not at all. It remains profitable to the tune of at least £800m and is one of the world's top three makers of aero engines. It has a £76bn order book, the balance sheet is strong, and liquidity is not in question; the business can clearly afford its restructuring. There may even be an element of "kitchen-sinking" going on East may be getting all the bad news out of the way now. And the longer-term outlook for large aero engine sales is good.

Boeing, for example, expects commercial aircraft demand to grow by 38,000 jets in the next two decades. More details are due at next week's investor meeting. East "cannot turn the juggernaut quickly", says Liberum analyst Ben Bourne. "He has to show that there is an improving trajectory on cash generation." But if that materialises "he might just get knighted in six or seven years'time".

Should Rolls-Royce be broken up?

In a word, no, says Olaf Storbeck on Reuters BreakingViews.com. "Even at Rolls' clobbered share price, a break-up makeslittle financial sense." Investec analysts recently estimatethe break-up value of the businesses (as at 5 November)at 513p. Even after last week's share plunge, the stock isstill trading around 7% above that, while the reduced profitoutlook suggests that the real sum-of-the-parts value hasfallen. "Warren East has promised to step up cost cutting andsteamline internal processes. That's less eye-catching than abreak-up, but still a wiser flightpath."