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Rolls-Royce can emerge from turbulence intact

Rolls-Royce's fourth profit warning in a year and a one-day 20 per cent drop in the share price will intensify the pressure on the UK engine maker to break itself up. Not least because its second-largest shareholder is US activist investor ValueAct. But that would be a kneejerk reaction to a problem that won't get better just because the company is in bits. Rolls-Royce, troubled as it is, can probably remain intact.

The Derby-based company on November 12 warned investors that the flight into 2016 will be even rougher than anticipated. The reasons include corporate jets going out of vogue, and older engines, which create higher service revenue, being used less. Chief Executive Warren East declined to give full pre-tax profit guidance. But he said that stiffening headwinds will dampen pre-tax profit by another £350 million next year. This shears a third off the previous analyst consensus, Reuters Eikon data shows. After abandoning Rolls' £1-billion share-buyback scheme in July, the dividend seems likely to get the chop too.
 
Rolls shares have lost 54 per cent over the last two years, during which time the FTSE 100 has only dropped seven per cent. A diversified corporate structure - the company makes marine engines and power systems as well as aircraft engines - is less of a factor than past strategic errors. A decision to exit the market for short-haul engines, now dominated by GE and Pratt & Whitney, was unfortunate since that market is growing strongly. A costly generational change in long-haul engines will clip earnings, probably for a couple of years.

Moreover, former management addressed the company's growing cost problem tardily. Low oil prices weigh heavily on investment in oil and gas exploration, hurting sales of marine equipment.

Even at Rolls' clobbered share price, a break-up makes little financial sense. Investec analysts on November 5 estimated the break-up price at 513 pence. The stock still traded four per cent higher than that on November 12, while the reduced profit outlook suggests the real sum-of-the-parts value has fallen. Warren East has promised to step up cost cutting and streamline internal processes. That's less eye-catching than a breakup, but still a wiser flight path.