Wednesday, 8 July 2015

BUY: Rolls-Royce Holdings (RR)--Preparing to Power Future Earnings?

Price: 783.8p
Shares: 86
Predicted annual dividend income: £19.57

Two purchase in quick succession. After my recent AstraZeneca top-up, I turned my eyes to a fresh addition helped by circumstances.

On Monday the news broke that Greece had voted "no" to accepting the bailout proposal offered to them. Over here in the UK the effect on the FTSE--although certainly negative--was rather more muted than I expected.

Nonetheless, Rolls-Royce Holdings was a stand-out faller with it edging near to a 10% drop in one day. This sharp day drop was preceded by drops of 1.52% and 2.28% the two trading days before.

Why? Well it seemed there was a perfect storm in the making. Greek crisis, a third profit warning and the company recently paying out their Final dividend. All in all, it seemed a large number of investors had decided it was time to jump ship for now. Fair enough.

Nonetheless, for me this was the perfect opportunity to jump on board. I have been wanting to initiate a position in the engineering giant for well over a year. So I was glad to do so when it was just above its 52 week low.

Why Rolls-Royce? The Good, the Bad and the Ugly News

Rolls-Royce's third profit warning in 18 months is obviously pretty bad.

The most recent one also added a little of the ugliness as well. Previously most of the profit concerns had revolved around the company's marine segment which was heavily tied to the fate of oil companies. To a large extent, this was to be expected in the low oil price environment.

However, the most recent profit warning reared a new, ugly head: profit warnings in the civil aviation segment. Previously this had been the more robust performer for the company.

Sounds bad doesn't it? Well, in the short term certainly. But let's put it in perspective.

Despite recent woes, the general record for Rolls-Royce has been pretty good. Earnings and dividends have grown consistently for many years despite being in a highly cyclical industry. Certainly, the possibility of negative cash flow in the most recent warning is a little worrying they remain--as we shall see--financially robust.

The profit warning also has the feel of a "clearing the decks" by the (very) new CEO, Warren East. East can afford to paint the ugliest picture of the past and present as even the most unfair shareholder is unlikely to blame him for it. It will also--with my cynical hat on--make him look even more heroic when/if he turns it around.

They are also making moves to sort out the issue. From cutting jobs to ending the share buyback scheme in the face of cash flow weakness.*

What is more, long term Rolls-Royce still looks an excellent company. Civil aviation continues to expand rapidly and this need planes (with engines) to facilitate it. At the moment, the major wide-body engine segment is--by and large--a duopoly between GE Aviation and Rolls-Royce. The split being almost exactly a 50/50 split between them.

What is more, new entrants are unlikely as the engineering expertise required represents a very high barrier to entry. All looks good there.

What is more, Rolls-Royce's additional TotalCare package in which the company itself provides maintenance and more to the operators of the engines adds further to earnings and makes it less cyclical in nature than many other manufacturers. All in all, I think the long-term qualitative story for Rolls-Royce continues to look excellent.

But let's take a look at the qualitative aspects.


As I noted earlier, Rolls Royce have an excellent record for earnings growth in recent years. In the last year and a half this nice record has been undermined. But what about the future earnings potential?

The analysts despite short term concerns certainly seem fairly positive. Clearly it is likely--in light of the fresh profit warnings--that earnings per share (EPS) will be revised down a little. But here are what the current predictions look like now for this year:

EPSP/E Ratio
Difference (%)71.39

On consensus predictions, we have a predicted earnings decline of 10%. Ouch. However, even with that it is predicted to provide a PE of just 13.4. For me that is excellent value especially considering the average PE for Rolls-Royce since 2010 has been about 16.

Of course, the lowest analyst predictions tells a very different story. It suggests a 40% drop in earnings and a PE of over 20. That is far less appetising. However, it is very much an outlier in the estimates.

Overall, next year is a little bit of a mixed message. But taking the consensus estimates, the company looks good value even with the predicted earnings pressure.

So what about next year? Well this is what the analysts anticipate:

EPSP/E Ratio
Difference (%)69.32

A return to growth is predicted across the board here. Consensus readings suggest an 8% jump in earnings and a PE of under 12.5. Again, this looks very attractive indeed.

What is more, even the most pessimistic analyst expects to see earnings jump about 9% next year. Clearly, a PE of 18.75 is less attractive but it is far from horrible in an environment in which many other manufacturers are trading at PEs above this level.

All in all, although not a picture perfect set of predictions, they look pretty solid. And, after all, it is the long-term growth I am looking at here and the fact that after this year growth is expected to bounce back pretty sharply is very encouraging.

Dividend: A Safe Income Stock?

Now to the dividend.

First of all, Rolls-Royce have an excellent dividend record. I have dividend data going back to the 1996/7 financial year. Since then the dividend has grown from 5.3p per share to the 23.1p of last year. During that time there have been no dividend cuts although between 2001/2 and 2005/6 it was held at 8.18p. That is a pretty excellent record of nearly 20 years of growth.

This growth record is predicted to continue going forward. For next two years the anticipated dividend is currently suggested at 23.74p and 25.95p per share. This would be a yield of 3.03% and 3.31%.

What is more, the dividend is well covered by earnings. Indeed, for this year and next it is covered over 2.4 times by earnings according to consensus earnings figures. Even using the lowest EPS predictions these dividends would be covered over 1.6 times by earnings. Not bad at all.

Also, the cash flow warnings raised by Rolls-Royce are slightly mitigated from the dividend perspective because they provide dividends in C shares. Although these can be exchanged for cash, it seems that most investors hold onto them or exchange them for ordinary shares which loosens pressure on the cash flow from this area.

Other Numbers

The company also looks in pretty rude health in other regards as well. Their debt stands at about £2.25 billion. This throws out a debt-to-equity ratio of 0.35 which is very modest indeed.

The company is also very cash rich with about £2.8 billion cash on the books. Not only--as you may notice--does that amount to more than their debt level but it also amounts to about 155p per share. About 20% of the share price. This is quite comforting.

All in all, this makes Rolls-Royce in pretty good financial health which bodes well.

Rolls-Royce and My Goals

So how does my Rolls-Royce purchase sit with regards to my investing goals for the year. A little clumsily, to be honest. 

My goal of having a portfolio yield of 1.25 times the FTSE All Share yield is slightly pulled back by Rolls Royce. At the time of the purchase the FTSE All Share was yielding about 3.4% meaning my target is about 4.25%. Clearly, the 3% yield from Rolls-Royce is going to pull me away from that a little.

Similarly, my target of £800 or more in dividend income for the year is not helped by this purchase. I have missed both dividend payments for 2015 so Rolls-Royce will add nothing to my total this calendar year. A little annoying maybe, but I am ahead of schedule with this goal already. 

Even on the volatility front Rolls-Royce is not a star performer. Although it has a modest beta value of 0.89 it is still higher than my portfolio target of 0.85. Then again, I am also ahead of this goal at present as well.

One goal for which it does help is my trading fees goal. For this purchase my trading fees amounted to just 1.24% of my total investment cost. Not bad, and it should help me keep my overall figure for the year below the targeted 1.3% mark.

What do you think?

Overall, I am happy with my Rolls-Royce purchase. Over the medium to long-term I expect Rolls-Royce to perform admirably as global megatrends seem set to favour a core part of the company's business. In the short term, though, I expect to see continued pressure on Rolls-Royce's share price which may mean a top-up will be in order. We will see.

What do you think? Have any of you added or topped-up your Rolls-Royce holding recently?


* Now, I have a slight issue with the pause in the share buyback scheme. For some reason they were happy chucking £500 million in share repurchases when the price was high but now pause the second £500 million promised when the price is low. Seems a bit odd. That being said, they are doing it for the right reasons.

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[Creative Commons image reproduced from Flickr user Red Fishing Boat]


  1. Hi DD, I think Rolls-Royce is a good choice. I looked at it about a year ago and said that 800p looked like good value, although at the time the share price was about 1,050p.

    Having said that, my "good value" price has now dropped a little, so the price would probably need to get sub-700p before I buy, but even sub-800p is still probably a good entry point.


    1. I am glad you agree, John.

      When it briefly dropped below 800p in October last year (when I missed it for lack of funds!) I set a sub-800 target for myself. I had a look to see whether I should drop it any further and decided not to even with the slightly adjusted circumstances. Fundamentally, my investment is not for this year or indeed next but for beyond that and with that time scope the value of RR has not changed for me.

      I do think it likely that the price will continue to be pressured downwards in the immediate short term so you may get your sub-700p price! Despite its strong order (which I forgot to mention above!) and excellent placement for long-term trends the sentiment is distinctly negative.

      I am happy to have pegged in a position at 782p for now. If it does drop lower I will happily bulk up the position! We will see! Patience, as is often the case, pays off!