Rolls Royce Holdings (RR.)


Rolls-Royce’s unwanted record

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Rolls-Royce’s unwanted record

Some of the optimism around Rolls-Royce (RR.) and the iconic engineer's slow recovery evaporated Tuesday, despite better-than-expected annual results. Currency hedging caused an eye-watering record £4.6 billion loss, and guidance was for only "modest" performance improvement in 2017 and free cash flow of only £100 million, similar to last year.

Rolls had already told us in January - alongside confirmation it had struck a deal with the UK Serious Fraud Office (SFO) and counterparts in the US and Brazil to settle allegations of bribery and corruption - that both full-year profit and cash would beat expectations.

With Rolls shares up 11% since, a lot of today's numbers news was already in the price, and perhaps explains why the shares fell as much as 6% Tuesday. There's a feeling, too, that a total dividend of 11.7p might have been more generous.

The firm made an underlying pre-tax profit at constant currency of £813 million, down 49% on 2015 but better than consensus estimates for £690 million. Revenue rose 3% to £13.8 billion, £300 million ahead of the market, and underlying operating profit of £915 million was a 15% beat.

Clearly, the weak pound since last June's Brexit vote has been a massive boost. It meant reported revenue rose 9% to almost £15 billion. However, Rolls made an "actual" loss of over £4.6 billion once you factor in a £4.4 billion hit from a revaluation of its $38 billion currency hedge book, used to manage shifts in foreign exchange rates. That's significantly more than anticipated. Losses also include £671 million in bribery and corruption fines.

Cutting costs faster than expected is certainly a boon. An enthusiastic Rolls made over £60 million of cutbacks in 2016, including hundreds of job cuts, ahead of the £30-£50 million target. It also thinks a further £80-£110 million is possible this year, making an annualised run rate of over £200 million likely by the end of 2017.


Across the divisions, civil aerospace made £367 million, 55% less than in 2015, and defence aerospace £384 million, both much higher than expected, though. Rolls' power systems business squeezed past forecasts and the struggling marine unit loss half as much as expected. Only the nuclear division missed targets, £4 million shy of consensus at £45 million.

In 2017, Rolls tips the civil business to make "modest" improvements to both top and bottom lines, margins and profit will "soften" at defence, power systems will be "steady", while cost-cutting should offset ongoing problems at marine, caused by weak offshore oil and gas markets.

Rolls is a hugely complicated business, and chief executive Warren East has done a grand job fixing the bits that weren't working. Remember, 2016 was the first year without a profits warning since 2014. But even he admits there's much more to be done to deliver "sustainable margin improvements".

We'll hear more on long-term goals over the next few months. In the meantime, East and his new team have their hands full, not least making the cultural and behavioural changes required to sharpen up the business happen.

"Management issued a reassuring message around the balance sheet – which we believe should reduce investor's concerns," said UBS analyst and Rolls fan Celine Fornaro. She still rates the shares a 'buy' and sticks with a price target of 835p.

There seems little doubt that the company has a brilliant future under East's stewardship, and Rolls is a business everyone wants to succeed. However, opinion remains divided near-term and the share price unpredictable.

Certainly, a break above the downtrend line on the chart above – currently 745-750p - would be significant. Making a move above it stick would provide a useful launchpad for a move toward Fornaro's target.

It's also worth keeping an eye on market forecasts for 2017. According to City analysts, revenue should improve to £14.2 billion and underlying operating profit to £1.05 billion.

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.