Growing pains hurt Rolls-Royce

More than a decade of rapid share price growth - only temporarily derailed by the financial crisis - came to an abrupt halt at Rolls-Royce in February. The aero engineer warned of a "pause" this year, but promised a return to growth in 2015. Crucially, it maintained guidance alongside a few other positives in these half-year results, yet many in the City remain unconvinced and Rolls has an awful lot to do over the next six months to win back support.

Indeed it does. A big currency hit and weaker equipment sales meant revenue fell more than expected in the six months to June - down 7% to £6.8 billion - and both underlying pre-tax profit and underlying earnings per share slumped by a fifth to £644 million and 25.6p, respectively. That, however was still ahead of subdued City estimates.

A 200 basis point increase in margin at the defence business gets much of the credit for the profits beat, which limited the slide in group margin at 150 basis points to 9.9%. Rolls has slashed costs there to offset the downturn in western defence spending. Equipment sales almost halved during the period to £376 million as demand for Eurofighter Typhoon engines, the Hawk trainer and C-130J military transporter dwindled. Full-year profit there could be down as much as a fifth, says Rolls.

On the commercial side, profit at the core civil aerospace division was down by a tenth at £405 million, hit by a rush of deliveries of Trent 1000 engines for launch customers, a weak corporate jet market and restructuring costs. But Rolls remains confident that full-year underlying profit here will be up as much as 12%, given decent visibility on equipment orders and services revenue.

Marine profit plunged by almost two-thirds during the half on pricing weakness, falling demand and a £30 million charge to fix a product quality issue. It’ll be down 15-25% for the full-year before the charge, more than first thought.

Despite this difficult first half, there were, at least, no nasty surprises. Both the power systems and nuclear and energy divisions should ramp up profits sharply this year, too, and further cuts are likely, especially at the civil aerospace business where cost control had never been a speciality. There's still a £71.6 billion to work through, net cash of almost £1.2 billion and money from the sale of the Energy division to Siemens will bankroll a £1bn share buyback.

Jeremy Thomas, co-manager of the Brunner Investment Trust, is certainly upbeat. "This short term discomfort gives investors an opportunity to buy a long term winner at an attractive price, in our view," he says.

Of course, the next few months will be crucial for Rolls, but management is clearly confident in getting the job done. "We expect significant improvement in profit for the second half driven by higher revenue and cost reduction," said chief executive John Rishton. "However, we will experience growing pains."

Unfortunately, earnings are experiencing pain, too, but with none of the growth. Rolls is tipped to increase earnings per share by only mid-single-digits next year. That's nothing special, and at 1,034p Rolls-Royce shares trade on a forward price/earnings ratio of over 16, a premium to both UK and European peers, and United Technologies which owns American rival Pratt & Whitney. There's technical support for the shares at a fraction below 1,000p, but few potential catalysts to really drive them higher until a capital markets day in October.

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.