Business Standard

Losing power

Rolls-Royce enters a new era of uncertainty

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Robert Cole
Rolls-Royce is flying in thick clouds with poor radar. After a savage profit warning in February, the company is again revising down its guidance. Disappointment from Rolls is starting to become the one thing investors can rely on.

True, the company is providing much more comprehensive guidance than before. An update on October 17 included detailed division-by-division revenue and profit guidance for 2014, as it warned that underlying revenue would be as much as four per cent lower, instead of merely flat. This impact would be offset by efficiency gains, hence underlying profit would not be affected other than by currency movements.
 
The visibility for 2015, such as it is, is worse. Rolls said overall sales might rise three per cent - or might fall three per cent. Next year's profit, it added, would be flat at best and could fall by as much as three per cent. The 14-per cent share price drop in response is hard to square with the face value of these statements. Investors clearly fear the forecast will prove too optimistic.

Supporters of the UK engineer have long drawn confidence from Rolls' promising exposure to robust global trends. Orders for its jet engines are underpinned by demand from emerging markets. In power generation, its modern turbines help customers enhance efficiency and reduce pollution. Meanwhile, Rolls' service agreements give recurring revenue that provides a cushion against fluctuations in orders for kit.

While that is a convincing investment case in the abstract, Rolls operates in the real world. Sanctions against Russia are dampening demand for Rolls' power systems, the company says. The lower oil price is deterring investment by drillers in Rolls' marine equipment.

A fresh commitment to cost cuts will help - especially as savings give Rolls some confidence about current-year profit. Management is also confident of generating a 13.5 per cent to 14.5 per cent return on sales.

But the investment case is changing. For all the attempts at providing clarity, investors have good reason for doubt. Before the warning, the shares were trading on a multiple of 14 times forward earnings, 14 per cent above peers. From here, Rolls will struggle to justify any premium at all.

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First Published: Oct 19 2014 | 9:31 PM IST

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