Shares of Rolls-Royce Holding (LSE: RR) fell by 3% this morning after the group admitted that new accounting rules would have reduced operating profits by £900m last year. But one of its smaller industrial peers is having a much better day. The company concerned said this morning that profits are likely to be higher than expected next year. The shares are up by 6%.
Is either of these stocks a buy after this morning’s news?
Accounting changes hit profits
Accounting changes mean that reported profits from Rolls-Royce may be lower than expected until 2022. What’s happening is that Rolls-Royce will no longer be allowed to recognise future revenue from engine maintenance alongside revenue from engine sales.
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Many of the group’s aero engines are sold at a loss. Profits are made from long-term engine maintenance deals. Major overhauls typically take place every five to seven years and are very profitable. But Rolls-Royce has historically brought forward some of this revenue to smooth out its annual profits.
From 2018, new IFRS15 accounting standards will mean this is no longer allowed. The group will only be allowed to recognise revenue in the year it’s actually paid. This means that from 2018 until 2022, profits from Rolls’ civil aerospace business are expected be lower than previously forecast.
To illustrate the impact of these changes, Rolls-Royce said this morning that if the new rules were applied to it 2015 results, operating profit would have fallen from £1,499m to £599m, a reduction of £900m.
I believe the changes are good news. Rolls’ profits and cash flow should match more closely and it should be easier for investors to value the stock. Under the old rules, Rolls-Royce shares trade on a 2016 forecast P/E of about 29, falling to 23 for 2017. In my view, that’s probably about right. I’d hold.
Results should beat expectations
Industrial group Fenner (LSE: FENR) has had a difficult couple of years, thanks to severe downturns in the coal and oil sectors. But conditions are improving. Fenner said this morning that profits for the 2016/17 financial year are likely to be “modestly ahead” of expectations.
The comments were made alongside the group’s 2015/16 results. These show that sales fell by 14% last year, while underlying pre-tax profit was down by 45% at £23.2m. However, Fenner’s strong cash flow remains an attraction. Operating cash flow only fell by 10% to £62.2m last year. This enabled it to end the year with net debt of £150m, slightly lower than expected.
An increase in the number of drilling rigs active in the US oil and gas sector is starting to drive higher demand for its products. Rising coal prices have also improved the outlook for the group’s conveyor belt business.
Fenner has maintained investment in its medical business during the downturn. Looking further ahead, the company believes this offers “significant new opportunities for growth.”
With Fenner shares trading on about 24 times 2016/17 forecast earnings, the shares are probably up with events. But today’s figures do give me confidence that further gains should be possible over the longer term.
