Rolls-Royce rockets as plan unveiled

There was a muted response to the teaser put out by Rolls-Royce early Tuesday. A short statement gave little away, and was certainly short on detail. The main course came late yesterday as the market was closing, and investors were clearly happy with management's plan to repair the cost-heavy engineer to financial health.

Rolls-Royce shares rallied in the last 30 minutes of trade Tuesday, and they're up another 2.5% Wednesday at 603p. That means they've recovered almost two-thirds of the 24% slump in the share price from 667p before the 12 November profits warning to 504p four days later.

After a breakout on the one-hour chart, the one-day chart now implies potential upside back to the pre-warning 660-670p region (see chart below).

But there's still a major disagreement in City circles about how effective new chief executive Warren East's turnaround plan will be. Former ARM Holdings boss East, who took over from John Rishton in July, rejected calls from shareholders to break up the unwieldy business.

"Rolls' [capital markets day] focused mainly on internal operational improvement, but in our view failed to address most of the medium and long term challenges," says Rolls-Royce bear Investec, moaning that while management plan to improve transparency, further disclosure on a number of issues has been deferred to 2016.

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"Yesterday was not the first time Rolls has promised that a material improvement in cashflow is only a "few years away". The candid presentation was refreshing, but headwinds to profit and cash are unlikely to dissipate soon and we think investors can afford to wait." 'Sell', says the broker, with a 420p price target.

And Rolls chiefs have yet to spell out how they'll tackle problems like A380 re-engineering, deterioration at the huge £2.5 billion revenue Power Systems division, and weak margins in defence. The debate about re-entering the narrow-body jet market also rumbles on, and the early retirement of Trent powered aircraft.

Sanjay Jha at Panmure Gordon called the sell off right all the way down from around 900p as far as we can tell. He still thinks the shares are a 'sell' and worth just 500p, worrying that while management predicts surplus cash flows in 2020, it is unable to see two years ahead as its information systems can't pick up short-term fluctuations.

"This creates uncertainty over cashflows and the balance sheet," says Jha. "If the company wants to maintain a £3 billion cash buffer then the prudent step at this stage would be to raise around £1 billion equity. Our forecasts show that that even if no dividend is paid next year, the company will end the year with just over £2.2 billion of cash."

"At this stage, we are giving the management the benefit of the doubt, and are assuming that some of the benefits of restructuring will boost operating profits in 2017," adds the broker, tweaking earnings per share (EPS) estimates a tad higher to 54.7p for 2015, but sharply lower for the next two years to 28.1p and 32.6p respectively.

Using those estimates, and with Rolls shares now at 603p and rising, the shares trade on over 21 times expected EPS for 2016, way above the UK sector average of 12 times and Rolls' long-term average multiple of 12.4 times.

Rolls requires a generous dollop of optimism

Of course, Rolls is not just a price/earnings (PE) story. Bulls will argue that investing here requires vision, and a generous dollop of optimism in East and his team.

Phil Buller at Barclays still needs some convincing. He has an 'underweight' rating on the shares, although the price target of 680p implies upside from here.

But while the "thorough" operational review presentation emphasised a clear intent to simplify the business and its disclosures provided much greater clarity on the underlying divisional performance from early next year, Buller has concerns:

"Of most immediate interest to us from a valuation perspective was the acknowledgement during Q&A that the Civil business as a standalone entity is currently cash negative to the tune of a couple of hundred million pounds.

"Whilst the near term demands on cash from R&D, heightened capex and increasing sales volumes of loss-making OE equipment is not 'new news', the lack of material cash generation from the operational installed base delivered over the past 20 years offers cause for concern."

Extracting greater value from TotalCare contracts and in a shorter timeframe is crucial, too, especially if Rolls is to justify current valuation multiples, argues the broker. Numbers suggest that, currently, many of these contracts are actually losing money.

It's also worth remembering that as new aircraft with more fuel efficient engines enter service, the retirements of Rolls' most profitable engines will likely accelerate. "It is this that may dictate the level of true underlying civil profitability and cash generation over the medium term, in our view," writes Buller.

"We do, however, note that consensus looks to 2017 as a year of a sharp reversal of fortunes for both free cash generation and earnings, which may be overoptimistic at this point."

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.