Hope has returned to Rolls-Royce. People are flying again and there’s a new boss with a decent CV promising change. Like his predecessor, Tufan Erginbilgic began his reign criticising how the group had been run. Investors, buoyed by favourable trading conditions and the prospect of the new chief executive finding the antidote to Rolls’ problems, are lapping it up. Faith, it appears, hasn’t been completely lost yet.
Erginbilgic, a former BP executive, needs to demonstrate that Rolls’ core aerospace business can generate sustainably enough cash to ease the strain on its balance sheet, restore an investment-grade credit rating and keep making the necessary investments (this is a very capital-intensive business, especially with today’s green agenda). Achieving that mission hinges largely on a sharp increase in long-distance air travel.
Rolls’ main job is designing, building, delivering and maintaining engines, primarily for widebody aircraft — reeling in customers and collecting later. Initial sales don’t generate much in the way of profit; the big bucks are made from servicing, spare parts and flying charges (Rolls gets paid each hour its engines are airborne).
Prospects are brighter three years after the pandemic grounded flights and almost pushed the group out of business. Flying hours and demand for new aircraft are rising. Trading conditions in Rolls’ other markets are improving, too. The capital goods sector is investing again and governments are beefing up defence budgets after years of austerity.
As things stand, the company is forecasting free cashflow of £600 million to £800 million. That would go some way towards reducing the big pile of debt and creating headroom for whatever initiatives Erginbilgic has in mind.
All of this has got investors excited. The shares are up 53 per cent this year, significantly outperforming the rest of the FTSE 100, and trade at 30 times forecast earnings. That implies there’s a lot of confidence in Rolls’ ability to deliver and doesn’t leave much room for the setbacks we’ve come to associate with the engineer.
Risks are plentiful. Other than the obvious threat of stubbornly high inflation and interest rates leading its generally cyclical customer base to tighten their purse strings, there’s the usual issue of waiting for the cash to pour in after new orders are placed. Competition is another concern. Rolls’ Trent engines have struggled with reliability issues, denting their credibility and paving the way for the likes of General Electric’s GE Aerospace and Raytheon’s Pratt & Whitney to steal market share.
The buzz surrounding the latest round of reviews also seems a little premature. We have no clear indication of what Erginbilgic will do or the damage he’ll find. All we really know is that the group was scrutinised by his predecessor not too long ago and that investors probably will demand something game-changing. There are only so many times you can use the generic “cost savings” pledge before people get tired and jump ship.
Bulls rightly can argue that within this sprawling mess exists a business capable of generating decent returns and that years of heavy investment and restructuring should start to pay off. Bears, on the other hand, could counter that numerous operational reviews conducted by other capable chief executives have yet to deliver the desired results and that the hole may be too deep to dig out of in a period of rapid technological change and investor impatience.
These risks were digestible when the shares were trading at about 65p. At 152p, more assurances are needed. Hold if you own, otherwise look elsewhere.
ADVICE Hold
WHY The recovery potential is there, but risks are aplenty and today’s share price isn’t low enough to bite
De La Rue
De La Rue has fallen so hard that even a shred of good news can send its share price soaring. Last Thursday, the maker of banknotes and passports said that demand for cash, its core product, was improving and that it had secured more breathing room from lenders. The shares have risen by 39 per cent since then.
A combination of bad luck and short-sightedness are to blame for De La Rue being valued roughly a tenth less than it was a decade ago. Cash is a volatile business. People increasingly pay for things with cards and when demand is there competition is fierce and governments penny-pinch, resulting in wafer-thin margins for winning bidders. Some countries don’t pay their bills.
Successive restructurings and changes in personnel have failed to result in a turnaround. Costs were slashed and new growth opportunities, including in greener, more durable polymer notes and authentication solutions, were pursued. Rather than revitalise the group, all we’ve seen is a series of profit warnings, criticism from shareholders about mismanagement and talk from auditors about one of London’s oldest listed companies potentially breaching its banking covenants.
Last week’s results helped to stem the negative flow of news. The numbers were largely uninspiring, but the biggest fears weighing on the shares were addressed positively. Demand for banknotes is rising and borrowing terms have been renegotiated, which, with a deferral of pension deficit contributions, eased pressure on a strained balance sheet.
At this price range, there are a few things to be encouraged about. Self-help and growth initiatives could spill over into greater profitability and other currency businesses have been flogged for way more than De La Rue’s present market value. That may be enough to tempt traders, but probably isn’t going to attract longer-term investors. It’s hard to build a solid “buy” case for a stock that frequently disappoints, is strained financially, is barely turning a profit and continues to make most of its money from something that people use less and less.
ADVICE Avoid
WHY Despite recent positivity, it still isn’t out of the dark
