Rolls-Royce continues to work through its current investment phase and external economic turbulence has not further damaged the prospects. The current shortfall in cash flow performance is being addressed. We believe the strength of the core civil engine model should ultimately reassert itself, lifting equity value towards significantly higher cash valuations.
The much downgraded expectation for FY15 was at least met, and indeed two unflagged one-offs actually led to a moderate beat of expectations at the underlying earnings level. As anticipated, the company has chosen to cut the dividend payment to shareholders, although a 50% reduction to the final amount was less than we expected. The FY16 interim is to be cut by a similar amount, with a further assessment at next year’s prelims. The main shortfall came in Marine due to the severely depressed offshore market. Civil was also weaker for the previously indicated reasons of lower legacy engine revenues and declines in regional and bizjet engine markets.
In the absence of a sixth profit warning in two years, one would hope that management is finally able to draw a line in the sand. FY16 headwinds remain in place, depressing group underlying profit before financing by £650m, with the finance charge returning to a more normal £103m and the group likely to turn FCF negative this year. In our view prospects beyond that look more favourable. However, the market is unlikely to rehabilitate the shares until renewed cash flow growth is demonstrable. As such, we see the current year as one of consolidation as the company prepares for further volume original equipment (OE) ramp ups in Civil, including the additional cost-down initiatives. We envisage a modest FCF improvement in FY17, with continued growth in the cash generative aftermarket and profitable recovery in other end markets providing much brighter prospects thereafter. Rolls-Royce should then be much better positioned.
The valuation of Rolls-Royce continues to look attractive on a long-term basis, but the near-term earnings declines continue to leave short-term multiples extended, with a lower yield support. We have revisited our capped DCF, which now returns a value of around 807p per share despite the dip in near-term cash performance. If management successfully implements the improvement plan, that should prove to be a minimum fair value.