Stockwatch: This blue chip will bounce back

Is Rolls-Royce a classic example of "the big unpopular company"? If so, then a potentially magnificent buying opportunity is in the making. This type of situation arises when a high-profile company hits trouble and disappoints the city: sentiment turns negative as brokers who once promoted the stock, advise "sell", and fund managers cut positions to avoid being seen clinging to a loser. Short sellers may accentuate the downside. But if a capable new chief executive is in place, fundamentals can change and the stock's high profile helps create another self-reinforcing trend - this time upwards. The main challenge is timing: while you don't want the frustration of a sideways-drifting stock, the market is likely to speculate on a turnaround before evidence appears.

At about 775p, the chart shows the stock ceding nearly all its post-2012 rally up to 1,289p in early 2014. Cyclicals re-rated as loose monetary policy encouraged risk-taking, but the table shows Rolls' rally was partly false because underlying profitability slumped. Based on the latest consensus the forward price/earnings (P/E) multiple is in the mid-teens - a fair approximation if the group can progress from a benchmark £1.3 billion, normalised pre-tax profit. Some uncertainties are involved, however.

Rolls has become complex to manage and value

In theory, diversification helps spread risk and smooth earnings, but diworsification can become the reality as a group takes on lots of interests in different areas. Together they may need more investment to achieve competitiveness than if the company had stuck to strong positions in fewer activities. Such is the dilemma for big groups trying to deliver growth. Instead of spreading risk, various issues can conflate, adding to the managerial challenge, like now at Rolls.

A potential saving grace is the newly-appointed chief executive, Warren East, who is an engineer by background and ex-ARM Holdings - a long-term technology success story from 1990s spin-off to FTSE 100 stalwart. He stands the best chance of anyone to devise and implement an appropriate strategy. That's one carrot, and why Rolls' P/E multiple is likely to trade at a premium to near-term earnings, anticipating better times ahead.

The stick is whether the global economic cycle peaks and enters some degree of downturn during the time it takes to achieve turnaround - say if financial crises in the eurozone and China become chronic with a ripple effect, just when US and UK central bankers need to normalise monetary policy by raising interest rates. Rolls' mid-teens P/E is currently near the top of the European aerospace sector average, and while that may be fair in terms of anticipating turnaround, in context it's not hugely appealing. Meanwhile, the prospective dividend yield looks to be 3% at best, assuming the board maintains a circa 22p per share payout (having ceased share buybacks). That's no great compensation relative to what plenty other stocks offer, so "support" for Rolls currently amounts to the extent of confidence in a new CEO honing better results.

Medium-term challenges but revenue growth potential

The current dilemma behind a third profit warning is a hiatus in ordering specific plane-engines, coinciding with the oil price fall reducing demand for engines used by oil rigs and supply vessels. The civil aerospace division is principal for Rolls, 54% of 2014 profit and 47% of turnover, while the "marine" side represents 8% of profit and 12% of turnover. The Airbus A330 replacement plane, equipped with the latest Rolls' Trent 7000 engine, won't enter service until end-2017, meanwhile airlines are less keen to buy the A330 with the existing 700 model engine - hence it has a faster than expected sales decline.

Coincidentally, and which may be a straw in the wind regarding the wider economic cycle, demand for business jets is weaker, likewise the regional jet aftermarket (parts and service). Such factors amount to a £300 million net "headwind" for 2016 although for 2015 it is mainly a £85 million shortfall on the marine side that accounts for 2015 pre-tax profit guided down to a range of £1,325 million to £1,475 million.

Marine is expected to have another difficult year in 2016, although the civil aerospace large engine aftermarket should then be improving; and looking further out "the successful roll-out of new engines...together with a growing aftermarket, is expected to drive significant revenue growth over the next ten years as we build towards a 50% share of the installed, wide-bodied passenger market." That's some juicy carrot.

Rolls will be in a major transition phase over the next three to four years though, hard to forecast reliably. Moreover, the latest review is really the work of the existing finance director and the new CEO plans a deeper review of operations. In principle it seems worth waiting for this to be published as new bosses tend to get any "kitchen sinking" done promptly and avoid regular exceptional charges muddying future results. The price of the new CEO's share options may get struck after his effective "start base" is established, another reason to wait. But in practice, if the CEO's review is positively received then Rolls' stock will rise, so averaging-in may be wise.

Stock bounces despite downgrades

While analysts have typically downgraded 2015 profit forecasts by 5% and 2016 by 17%, views are mixed on the cash impact. Management guides cash flows at about £600 million for the first half of 2015, up from £347 million like-for-like, and says cash conversion should improve in 2016, although a £1 billion buyback programme has been suspended half-way. Price targets have been downgraded for example to about 650p, which represents 14 times 2016 consensus earnings, and yet the stock has rebounded from 750p to 775p - showing how the overall market senses a recovery play in prospect. Interim results are due 30 July, and it will be interesting whether any directors buy stock thereafter.

It's a complex situation, but the crux is a top-calibre new CEO having strongly established businesses to work with, despite near-term issues and risks in the global economy. Rolls' stock will eventually rise, with a bandwagon effect as a high-profile company. It's one to watch and consider steadily buying into.

For more information see rolls-royce.com.