City view: 3 ways for Rolls-Royce to re-rate

Rolls-Royce is down by over a third in 2014. Britain's favourite engineer has issued two profits warnings, the second in October after an earlier forecast for flat profits in 2014 was extended into next year. Investec Securities has considered three strategic options available to the fallen giant.

Of course, Rolls operates in long-term end markets and the way it deals with fluctuations reflects elongated investment cycles. "We understand this, but believe that unless the operational and financial performance can be improved then shareholders will demand change, especially as the different options appear to provide material upside on much quicker timescales," says Investec. "A successful long term strategy needs to be based on consistent delivery over a number of shorter periods."

And the government's "golden share" in Rolls, held since privatisation in 1987, means a takeover in its current form is unlikely. It effectively gives politicians the power to prevent another shareholder from owning a certain stake in Rolls or block a takeover or acquisition by another company. So, what are Rolls' options?

Option 1: Break the group into two listed entities:

Rolls could decide to break up the group into an aerospace business and a land & sea industrial operation. This could spark a re-rating for both entities, argues Investec. Just look at Vesuvius, the old Cookson business which re-rated by about 30% relative to the FTSE All-Share over the 12 months following the break-up of the industrial conglomerate. "We see c20% upside to the current share price under this scenario," says the broker.

Option 2: Sell the non-aerospace divisions and return cash to shareholders:

"We believe that in this scenario Rolls would be able to crystallise value earlier than in our 'status quo' scenario," reckons Investec. "We believe it is likely the shares would re-rate to the premium PER valuation of c20%-40% relative to the market at which they have traded in the past, which implies c.20-40% upside."

A pure play aerospace business is still the preferred option for many shareholders, thinks the broker, with a possible cash return of about £6 billion, or 330p per share. "While attractive on paper, we do accept that this might not be an optimal time to sell industrial assets that are exposed to currently challenging end markets."

Option 3: Maintain the "status quo", becoming a diversified industrial rather than a pure play aerospace company.

"This is our base case assumption, and drives our formal 12 month target price and recommendation," writes Investec. It rates the stock a 'hold' with 900p target price.

"If management can convince investors of the benefits of this strategy and improve communication, we do believe that the shares will eventually re-rate to the c20-40% premium that Rolls has enjoyed in the past." That said, restoring investor confidence could take "a number of years."

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.