2016 has begun on much better terms for industrial heavyweight Rolls-Royce (LSE: RR) than the annus horribilis that was 2015. Following a series of profit warnings, signs are emerging that new CEO Warren East is up to the task of turning around the struggling engine maker.
Chief amongst East’s tasks is to improve woefully low margins in the core civil aerospace business. Operating margins for this division, which account for over 50% of revenue, fell from 13.8% to 11.7% year-on-year. This is nearly half the 22.3% margins GE’s aviation division enjoyed. This is an important comparison because GE and Rolls essentially share a global duopoly in wide-body engines.
The key to margins improving enough to catch GE’s will not only be the £150m-£200m in annual cost-cutting management is targetting, but also the natural cycle of engine development. Rolls is just now rolling out its new generation of Trent engines, which is typically a break-even process. The real profits are made on engine maintenance contracts, especially as they age. Seen in this light, Rolls is at, or near, the bottom of a cyclical trough.
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While growth may not be runaway in the coming years, engine makers have a significant moat to competition. And if East can continue to cut costs while maintaining significant R&D operations, the future for Rolls should be bright indeed.
Staying power
Shares of insurer Prudential (LSE: PRU) have had a rough run lately after the departure of wildly successful CEO Tidjane Thiam and the slowdown in China, to which the company is heavily exposed. Despite these fears, Prudential’s underlying business continues to perform well. 2015 year-on-year operating profits rose 22%, driven by a 28% increase in new business profits from Asian operations.
This continued success in Asia, despite the poor economic news from major markets such as China, shows the staying power Prudential has. Starting from its enviable current market position in China, the future growth in insurance and asset management needs for China’s growing middle class is vast. Combined with continued solid performance in the US and UK, Prudential is beginning to look like a steal trading at 11 times forward earnings with a 3% yielding dividend.
Bright future
Trading at under 10 times forward earnings with a 5.5% dividend, oil services provider Petrofac (LSE: PFC) is another great company trading at depressed prices. Shares have slumped alongside the industry as a whole, even though Petrofac’s underlying business continues to perform soundly. Revenue for 2015 rose 10% year-on-year, although profits tumbled to $9m after a disastrously expensive Laggan-Tormore project in the North Sea.
While net debt of $686m is a worry, this shouldn’t be too much of a problem with strong operating cash generation, which hit $827m in 2015. The company’s order backlog stands at a record $20.7bn as its main customers, Middle Eastern national oil companies, race to keep their ageing wells pumping at full volume. With final writedowns related to the Laggan-Tormore projected to be booked in the first half of this year, the future for Petrofac looks quite bright to me as profits bounce back to once again cover solid dividend payouts.
