Rolls-Royce divides opinion as D-Day approaches

Yesterday, we ran a story on Rolls-Royce, describing how one analyst thought the shares were only worth 420p. Another warning is highly likely, argues Investec Securities, given a series of strategic, end market and accounting headwinds.

And, it's true, the immediate outlook is pretty grim. However, a day later and two rivals share a more upbeat outlook which - in the interest of fairness - is worth examination.

UBS admits that last week's profit warning was "clearly unwelcome and painful". It's slashed forecasts and reckons Rolls will cut the dividend to zero to avoid paying it out of debt. The price target also reduces from 980p to 750p.

"Beaten, but not defeated," writes Sandy Morris at Jefferies. Again, he's thrown the proverbial kitchen sink at forecasts, which causes the target price to plunge from 1,100p to 700p - "this feels to us like abject surrender," admits Morris.

And, again, dividend estimates are cut - from 23.1p in 2015 to 15p. Yet he's still not convinced the balance sheet could not support a maintained dividend.

"This forecast has no substance to it other than our belief that the best thing Rolls-Royce can do is to behave normally," he says. "If the dividend is not adequately covered by either earnings or cash flows, but there is a need to guard the credit rating against some future or further volatility in the trading backdrop, then the dividend should reflect that, in our view."

A long-term play

But both analysts agree that Rolls now becomes a long-term play. "Rolls-Royce investment thesis is a 2019/20 story and the market needs to look beyond the near/medium term," says UBS.

"Now, more than ever, the company needs to provide the market with the requisite building blocks to establish a credible roadmap of how the various elements of cash flow and profit will stack up over the next four-five years."

It could come as early as Rolls' capital markets day next Tuesday, 24 November. Failure to give the market a roadmap will only delay the process of re-establishing credibility in the long term.

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Jefferies has dropped forecasts for pre-tax profit in 2016 to just £605 million from £1.3 billion this year, rising to £760 million in 2017. That gives underlying earnings per share (EPS) of 25.2p and 31.4p for 2016/17, respectively. That does not include inevitably significant restructuring charges.  

UBS pencils in EPS 31.3p and 30.4p for 2016/17, which compares with Investec's bear case yesterday, which tips a slump to 25.4p and 28.1p.

'Wrong' to judge Rolls on EPS?

Even using the most positive of these estimates, Rolls-Royce trades on 18 times EPS estimates both for 2016 and the year after. But Morris believes it is "quite wrong" to value Rolls solely on EPS:

"The power of the aftermarket is still funding high investment in R&D and capital expenditure - and OE [operational expenditure] losses too, for that matter. Failure to recognise the aftermarket will grow and failure to recognise at all what that means for future [free cash flow] may be understandable, but incorrect. Hence our 700p price target and our 'buy' recommendation."

If the focus does remain firmly on EPS, Morris worries that the share price could struggle to exceed 600p. On the flipside, get a clear account of civil engine aftermarket cash flows on the 24th and "perhaps 800p could be reached within our 12-month horizon".

At UBS, the team bases its 750p target on discounted cash flow (DCF), using cash conversion of 80%, five-year profit growth of 16% and a weighted average cost of capital (WACC) of 9%. That implies a fair value multiple of 16 times estimates for enterprise value/underlying operating profit in 2016. Improve cash flow to over 100% in the long term and fair value stretches to 940p.

In summary, little is likely to change ahead of next week's capital markets day.  Deliver a convincing roadmap on the 24th and investors may give Rolls the benefit of the doubt.

Attention then switches to execution. Given the sheer size and complexity of the business, it will be no easy task. What is clear is that decisions made in the next few weeks and months will define new boss Warren East's tenure. Their importance cannot be overestimated.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.