If there is one FTSE 100 company that epitomises the rough and tumble of the stock market in recent years it has to be Rolls-Royce (RR.).

The £15bn company makes engines and huge gas turbines that power planes, trains and ships. It has enjoyed prolonged spells of growth over the years.

However, it has also been struck down by a corruption scandal and multiple profit warnings in recent years that nearly saw the company fold, according to its current chief executive Warren East.

In the decade since the global financial crisis the share price has traded through a sweeping range of lows worth 258.5p and highs of £12.71, a record for the stock.

The latest set of full year results (published on 7 March) appear to underscore the positive effects of a recovery plan put in place by chief executive Warren East about two years ago.

Rolls-Royce’s shares notched up the biggest gain on the FTSE 100, jumping 11.5% on the day to 924p, with those results (covering the 2017 financial year) showing every division performing better than analysts had forecast.

Underlying pre-tax profit topped £1bn, well ahead of analysts’ forecasts and up 25% on 2016 equivalent figures.

That makes 2017 the first year of profit growth since 2013. There was also a significantly improved cash performance, churning out nearly £1.3bn of free cash flow versus the £490m cash burn in 2016.

East is now pressing ahead with the next phase of his strategy to repair the tarnished reputation of this former UK engineering champion. Success could mean significant returns for shareholders, while further failures could potentially see the group broken-up and sold off piecemeal.

PLANES, TRAINS, SHIPS… NOT CARS

Let’s be clear, we are not talking about luxury Rolls-Royce cars. Those fancy autos are made by BMW and have been for years.

The UK-listed company is an engine specialist and its business model is fairly simple to understand.

It designs and builds aircraft engines for Boeing, Airbus and the Eurofighter Typhoon; it provides propulsion systems for the Royal Navy’s nuclear submarines and new aircraft carriers; plus engines for trains and commercial shipping.

It makes very slim profit on average on the actual sale of engines. Some are even sold below cost as a loss-leader. The profits come from parts and servicing contracts over typical 25-year engine lifecycles.

As you might expect, this ramps up with age. A new engine doesn’t require much fixing in the early years, but once they hit about five years old wear and tear begin to take their toll, giving Rolls-Royce about 20 years of premium profit and cash flow.

CIVIL AIRCRAFT DUOPOLY

Commercial aircraft is by far its most important segment where it is half of an effective global duopoly with General Electric.

One in two passenger planes are powered by Rolls-Royce engines, and it has recently been taking incremental market share from its US rival. A little more than half of revenues come from civil aviation contracts.

East took the top job in 2015 and, after a spell getting to know the company’s operating ins and outs, set out a programme to improve efficiency and sharpen the company’s focus on execution.

The decision to put the commercial marine business up for sale and shrink the number of divisions from five to three is the latest move to simplify the company.

Going forward operations will be based around civil aerospace, defence and power systems.

Particularly interesting are plans to development hybrid-electric engines. This will come partly through a strategic partnership with German engineering group Siemens, with hopes of having a test aircraft ready to fly by 2020.

But Rolls-Royce can also lean on its existing electric expertise developed in the rail industry.

WINNING BACK MARKET TRUST

The potential to bear fruit has started to win over City analysts and investors. We recently attended a presentation by Ramesh Narayanaswamy, an investment analyst at Veritas Asset Management, who explained the extensive and
long-winded analysis process prior to the asset manager’s stock purchase. Veritas now owns 2.7% of Rolls-Royce.

The Veritas team had tracked Rolls-Royce since before 2013, but only pulled the trigger and bought stock after a corruption scandal fall-out saw the share price plunge towards the 500p levels.

The asset manager took the view that the long-run nature of Rolls Royce’s servicing contracts underpinned its future, and that free cash flow holes could be plugged relatively rapidly. It is an opinion that more of the market is now embracing.

In December 2016, for example, 13 of the 25 analysts who followed Rolls-Royce had a ‘sell’ rating on the stock. Just two optimists flagged the shares as a ‘buy’ while the rest sat on the fence with ‘hold’ calls.

Today the number of ‘buy’ recommendations has doubled while ‘sell’ ratings have fallen to six.

There is clearly much more work for East and his team to do, both operationally and in rebuilding confidence in the market, but there are more positive signs now than over the past few years.

We’re big fans of the company and believe the shares are well worth buying if you have a long-term investment horizon. (SF)

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