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Rolls-Royce's [RR] share price has stalled, will it restart?

After a promising take-off to the new year, Rolls-Royce Holdings Plc [RR]’s steep share price climb has moved in the opposite direction. The engineering group opened the year by erasing some of the losses made at the end of 2018, rising almost 20% to 988.4p within the first two months of 2019. A large proportion of those gains, however, were been erased at the close of February, as full-year results revealed a loss of £2.9bn, compared a £3.9bn profit in 2017.Rolls-Royce 1-year share price performance, CMC Markets, as at 14 March 2019

 

While the bottom line was largely driven by fluctuations in hedging contracts, results still showed an operating loss of £1.1bn, compared to a profit of £366m in the previous year.

The company’s earnings have been plagued by stubbornly-increasing repair charges on a flawed engine, the Trent 1000. Since 2016, several design issues have surfaced in the engine – which powers Boeing’s 787 Dreamliner long-distance plane – forcing Rolls-Royce to upgrade components and lower estimates around the engine’s safe life.

 

Profits hit

In 28 February’s full-year results, chief executive Warren East put the cost of repairs and compensation to customers at £1.5bn, up £100m from previous estimates. Exceptional charges, which had totalled £554 in the six months to June alone, ballooned by a further £236m in the second half. Rolls-Royce will go on paying the remainder of the £1.5bn until 2022.

£1.5bn

Rolls-Royce repair and customer compensation costs in 2018

The hit to profits didn’t just stem from engineering problems. 2018’s earnings report was the first filed under IFRS 15, an overhauled accounting standard for recognising revenues. The company’s long-standing practice was to book revenues from multi-year servicing contracts in advance, which compensated for the average £1.4m loss it still makes on each engine sale (though that number is decreasing rapidly). The approach had long raised analysts’ eyebrows, and IFRS 15 – which makes income only bookable at the point the service is performed – slashed several hundred millions from reported profits.

Analysts have also taken concern with recurrent use of what are supposed to be “exceptional charges”, which the company strips from “core” underlying profits. A case in point: the costs the company will incur until 2022 on the Trent 1000, “a fleet-wide issue of an unusual and abnormal scale”. In a note following the 2018 results, JP Morgan said Rolls-Royce’s reporting “has become less conservative in our view, with underlying financials that are considerably weaker than headline numbers”.

 

Cost cutting

Much like the aircraft powered by the company’s engines, chief executive East sees Rolls-Royce as perfectly capable of flying at high altitudes. “Rolls-Royce is a growth business and a strong revenue growth business as well,” he told investors following the earnings announcement. “A lot of our expenditure goes into vitalising our existing capabilities. That means [the] products and services that we operate today, how we make sure we continue to operate those and develop new versions of products and services ever more cost effectively.”

“Rolls-Royce is a growth business and a strong revenue growth business as well” - Rolls-Royce chief executive Warren East

Cost-cutting in middle management has been a big focus of East’s tenure, now almost in its third year. In 2018 alone, the company cut 1,400 jobs, with anticipated savings of £400m by the end of 2020. It also disposed of L’Orange, a German manufacturer of components for diesel engines, and is aiming to reduce operating units from five to three.

At the same time, East has stepped back from targets he deemed too ambitious. One of the larger pieces of news to come on 28 February was that Rolls-Royce would pull its bid to supply engines to Boeing’s mid-market aircraft. Boeing wanted to launch the aircraft by 2025, but East – mindful of cutting corners, provided what happened with the Trent 1000 – said Rolls-Royce would only be able to complete testing in the latter half of the 2020s. And a few days later, the company said it was scaling down its contribution to a joint venture with Turkey’s Kale Group to build the country’s first locally made jet, the TF-X.

 

Looking east

Rolls-Royce does have ambitions for expansion. It’s planning to build market share in China, and is betting on hybrid engines for trains as emission regulations get more stringent.  The firm recently signed a £850m engine deal with China Eastern Airlines to provide its Trent XWB engine to 20 Airbuses.

 

Market cap£16.79bn
EPS (TTM)-129.20
Operating margin (TTM)-7.26%

Rolls-Royce stock vitals, Yahoo finance, as at 14 March 2019

 

But the current priority for management is getting cash flows in order: East achieved £641m of free cash flow during the year, and is aiming for £1bn by 2020.

It means East will likely be in no rush to rise dividends above the current full-year mark of 11.70p per share. But East did say that the dividend will be up for review in 2019, and that he intends to “restore it to previous levels”. Whether he means 2016’s 16.37p, or even 2015’s 23.10p remains to be seen.

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