Interactive Investor

Divi halved, but Rolls-Royce breaks out

12th February 2016 13:53

Harriet Mann from interactive investor

For the first time in a quarter of a century, Rolls-Royce has cut its dividend. The iconic aerospace and defence engineer has issued a handful of profits warnings over the past two years and a cut in the payout had been well-flagged. Full-year results were actually better than expected, which is why Rolls shares have staged a dramatic breakout above stiff technical resistance.

While underlying revenue slipped 1% to £13.4 billion at constant exchange rates, pre-tax profit sank 12% to £1.4 billion, benefitting from a one-off intellectual property settlement and £19 million Research and Development credit. Strip these out and underlying pre-tax profit totalled £1.35 billion, in-line with guidance. On a reported basis - not including adjustments for financing, revaluations and derivative contracts - pre-tax profit jumped by 140% to £160 million.

Targeting £145 million of annual savings by 2017, the group's major restructuring programme kicked off in November last year. Around half of targeted cost savings have already been identified, and Rolls wants eventually to make £150-£200 million of savings each year.

Of course, restructuring doesn't come cheap and, with a £75-100 million charge expected in 2016 alone, free cash flow will suffer. In order to protect its credit rating, management halved the 2015 final dividend to 7.1p, taking the full-year pay-out to just 16.37p.

"Subject to short-term cash needs, we intend to review the payment so that it will be rebuilt over time to an appropriate level," the company said. Rolls will also halve the interim payout, which was 9.27p last year.

Like a moth to a flame, Rolls has attracted income investors in the past with a reliable dividend yield just shy of 4%. This has now plummeted to 2.6% for the upcoming pay-out.

Rolls' flagship civil aerospace business generated £6.9 billion revenue in 2015 and £812 million pre-tax profit, representing top line growth of 3% and a 14% decline in profit. A heavier order book reflects strong demand for its operations, however, with the division accounting for over half of the closing book. That said, there are some concerns over weakening second-half demand in Power Systems and increased costs at Defence and Nuclear.

Pleased with management's decision to protect the balance sheet, Rolls-Royce spiked 16% to 614p straight out of the blocks. Although the shares have bounced from near-six-year lows, they are still down a whopping 42% from 52-week highs of 1,061p. So - have we seen the bottom?

Possibly not. Although Rolls avoided another profits warning, earnings per share (EPS) might be hit by higher tax and interest charges. Acknowledging downside risk, Investec analyst Rami Myerson has pencilled in EPS of 24.6p for 2016, less-than half last year's total, which puts the shares on a forward price/earnings multiple of 25 times. While the group seems confident in the long-term benefits of its transformational programme - and so are we - there are clearly short-term risks and this recovery multiple does look spicy.

Placing his 440p target price under review, Myerson agrees: "Our view remains that the premium valuation does not reflect a series of medium and long term challenges to profits and cash." He still rates the shares a 'sell'.

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.

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