How Rolls-Royce could touch 420p

The latest in a string of profits warnings from Rolls-Royce triggered a stampede to downgrade forecasts last week. But even now there's talk that this may not be the end of it, with dramatically lower consensus forecasts thought to remain at risk. Rolls shares bounced from a near-six-year low on 16 November, but one analyst thinks the shares are massively overpriced.

"The latest profit warning is unlikely to be Rolls' last and we continue to see further downside risk to consensus forecasts in the short and medium term from a series of strategic, end market and accounting headwinds," warns Investec Securities.

"Risks to earnings remain to the downside and the valuation (FY16E price/earnings ratio of 21.8x and 19.8x in FY17E) suggests these may not be reflected in the current share price. We reduce our target price to 420p and reiterate our sell rating."

Investec has slashed forecasts for adjusted earnings per share (EPS) for 2016 by 31% to 25.4p, and by 30% for 2017 to 28.1p. That reflects the extra £350 million of headwinds at the civil aerospace and marine divisions.

Don't bank on the dividend being maintained either. Despite increasing the payout by 3% at the half-year stage to 9.27p, Investec reckons the company will be forced to halve the dividend for 2015 and the next two years to 12.1p, 12.8p and 13.5p respectively.

"We believe Rolls will likely opt to increase earnings cover to strengthen the balance sheet and maintain the current credit rating," it says.

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But this factors in only the known downside risks. Known unknowns not reflected in these forecasts include the cost of re-engining the A380, the adoption of the IFRS 15 accounting standards, a decision to re-enter the narrowbody market, and shorter useful aircraft lives.

And if Investec is right, operating profit at the Power Systems division will be nowhere near the £200-£250 million implied by company guidance. Think more like £134 million!

"The downgrades to Trent 500 and 800 engine aftermarket revenues should increase investor concerns on the useful lives of Rolls' engines and the embedded value of the installed base," adds the broker.

Investec's new numbers chime with our back-of-the-fag-packet calculation in the aftermath of the 12 November warning. Investec had already cut forecasts days before, and applying those estimates to the long-term average multiple of 12.4 times gave a price target of less than 460p.

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