Rolls-Royce has a long record of disappointing shareholders, so any sign of delayed recovery understandably receives harsh punishment. Missing the market’s revenue and profit expectations for the first half of the year yesterday wiped almost a tenth off the industrial specialist’s market value.
Underlying revenue rose by 8 per cent over the six months, but underlying operating profit fell to £125 million from £307 million in the same period last year. Warren East, the outgoing chief executive, blamed the non-repeat of a foreign exchange-related credit last year, but engine shop visits and engine deliveries were lower than expected in its core civil aerospace business, caused by supply chain constraints and delays in spare engine sales.
The underlying profit margin declined to 2.4 per cent from 5.9 per cent during the same period last year. The company has maintained a target to hold the operating margin at about last year’s depressed levels of 3.8 per cent, but a weaker performance leaves Rolls with heavy lifting to perform at a time when cost inflation is accelerating and the timing of the aviation sector recovery remains uncertain. So while the free cash outflow has shrunk to £77 million, a target to be in positive territory is more questionable if profitability doesn’t improve.
Rolls’ share price remains 65 per cent lower than it was at the end of 2019, but, after taking into account the group’s hefty debts, it is still being valued with little doubt that recovery will materialise on time. An enterprise value of just over seven times forecast earnings before tax and other charges for the next financial year is not appealing.
Rolls may be forging into other sectors, including defence and power systems, but its fortunes are inextricably dependent on the civil aviation industry. Specialising in producing and servicing engines for long-haul aircraft means sales have been hit severely by the grounding of flights during the pandemic.
Under its engine servicing model, Rolls charges customers a fixed amount on a “per flying hours” basis. Large-engine, long-term service agreement flying hours have improved but remained just above 60 per cent of 2019 levels by the end of June. The company is banking on a further recovery in flying hours but doesn’t expect to get back to pre-pandemic levels until 2024.
Guidance for a return to a positive free cashflow position at the full-year is dependent on higher spare engine sales and large engine shop visits. But Rolls is also battling supply disruption and has flagged challenges in hiring, particularly for experienced engineers. Both factors could prove banana skins for its sales recovery, although the group says it has been building inventory across its businesses. There is also the profit challenge of rising inflation, which could bite harder on margins next year.
At least the balance sheet should soon be in better shape. Net debt stood at £5.1 billion at the end of June, as the company has burnt through cash in recent years. The sale of ITP Aero for €1.7 billion marks the completion of Rolls’s key disposal programme, aside from any tinkering around the edges. Proceeds from the sale will be used to pay back a £2 billion loan early, which will leave Rolls with only fixed-rate debt. The relative youth of Rolls’s civil aircraft engine fleet means there should not be a need for any big research and development spending in the near term.
Tufan Erginbilgic, Rolls-Royce’s incoming boss, will need to deliver more tangible evidence that it can deliver sustainable free cashflows.
ADVICE Avoid
WHY The shares are not attractively priced given uncertainty around aviation recovery and the threat of inflation on margins
Next
Pandemic lockdowns expedited the Darwinian struggle among high street retailers. Next has enjoyed the spoils to be had from a return to shops and less competition for customers through the doors, as rivals have retrenched. Stronger in-store sales during the second quarter have prompted the clothing retailer to push full-year profit guidance up by £10 million to £860 million, almost 5 per cent higher than last year.
An acceleration in store sales, helped in June and July by unusually hot weather, isn’t expected to last. Against the pre-pandemic level, retail sales in July were down 0.6 per cent. Lord Wolfson of Aspley Guise, the chief executive, has a record in prudent forecasting and last year the company upgraded its profit guidance four times.
With inflation worsening and a recession looming, Wolfson has maintained sales growth guidance of 1 per cent for the second half of the year. Thus far, promotional activity hasn’t increased, but the retailer has tightened inventory levels to prepare for weaker sales growth. There has not been any sign of Next shoppers trading down on items, either; instead, Wolfson said, they had bought fewer items that are of better quality and higher in price.
What about Next’s own budget controls? The cost of stock increased by 3.5 per cent during the first half, which is expected to rise to a rate of 8 per cent during the latter six months of this year. Product inflation can be recouped through price increases, but other costs, such as freight and energy, will curtail profit growth.
The shares trade at just over twelve times forward earnings, compared with a multiple of eight for Marks & Spencer. Next’s edge over its high street rivals has been in making the symbiotic relationship between online and in-store work profitably. A long-term record of consistent underlying sales growth has earned Next more credit from investors than its high street peers.
Next is highly cash-generative and frequently has returned excess cash to shareholders over the past two decades. So far this year it has spent £224 million on share buybacks. Compared with its retail peers, Next looks far better placed to withstand a darker trading period ahead.
ADVICE Hold
WHY Well placed to recover from weaker spending
