Rolls-Royce: takeover whispers as headwind strengthens

by Sean Flynn, Shares magazine

Aerospace and defence behemoth Rolls-Royce finds itself on something of a sticky wicket having issued its third profit warning in 18 months on 6 July.

This was not the dream start for new CEO Warren East. The £13.9 billion cap highlighted headwinds in the civil aerospace business where profit could be reduced by £300 million in 2016 due to a softening regional jet aftermarket business as well as ongoing impact from reduced Trent 700 deliveries.

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Rolls-Royce's share price has declined by almost a third over the past 12 months and the latest guidance will not please its outspoken activist investors. The group's strategy of diversification has come under increasing criticism and Douglas Ott II, chief investment officer at shareholder Andvari Associates maintains that the group's poor performance "can in part be explained by the softness in defence spending, but can also be explained in larger part by poor performance in the non-aerospace businesses owned by Rolls."

The group designs, manufacturers and support power systems for numerous different markets. The largest business is civil aerospace, generating 40 per cent to 50 per cent of annual sales. Rolls-Royce provides propulsion systems for defence aircraft, military and commercial vessels and energy markets. Its power systems and marine divisions specialise in reciprocating engines. The other half of its revenue comes from after-sales service with contracts often running for 20 years or more.

Cash in the short to medium term remains a problem at Rolls-Royce. With expectations for 2015 free cash flow lowered to between minus £150 million and £150 million, the group's share buyback scheme, which is only half completed at £500 million of the planned £1 billion programme, has been discontinued.

The group's marine business is also likely to remain under pressure. Profitability continues to suffer while Rolls-Royce struggles to implement further cost reduction and restructuring activities in that division. The group now expects underlying profit in the segment to be between break-even and £40 million, compared to previous guidance of between £90 million and £120 million.

East has launched an operational review of Rolls-Royce's businesses and Rami Myerson at Investec maintains that this "should include a review of Rolls' strategy to become a diversified industrial company".

It is not readily apparent that Rolls-Royce intends to revisit this question. As the recent update suggests, East is primarily focused on managing the transition from the Trent 700 to the new Trent 7000 as well as building capacity to service the Trent 1000 and XWB programmes. For the time being, Rolls remains wedded to trying to sort out its marine business rather than selling it off.

But could the business be a takeover target? RBC Capital rubbishes talk that United Technologies could be interested, saying such suggestions are 'baseless' as it is looking for smaller targets. Siemens has also been tipped as a potential suitor.