A Rolls model to avoid

BLUE CHIP: Weak markets and an impatient City have sent shares in the aero-engine maker into a tailspin

THE CITY seems to have finally lost patience with Rolls-Royce - the aero-engine manufacturer, that is, not the more glamorous and successful car company.

After years of promising jam tomorrow, R-R still looks to be struggling. Recent poor results sparked a raft of downgrades - 11 at the last count - and a number of sell recommendations.

Some savage restructuring and the timely purchase of Allison, the US engine maker, have done little to address fundamental problems that are outside R-R's control. Both the power generation and, more importantly, the civil aircraft markets are weak.

Last week's welcome news of Saudi Arabia's $6bn (pounds 3.8bn) order for aircraft from Boeing and McDonnell Douglas will mean spin-off work for R-R. But such huge orders are the exception, not the rule, these days.

R-R's main customers, the airlines, have suffered the twin impact of declining passenger volumes and a drop in fares caused by deregulation.

Airlines are using aircraft longer and buying fewer spares, which are a high-margin contributor to profits. Boeing, which has cut production rates on certain aircraft, is facing a strike that could have a damaging knock-on effect for suppliers.

Aircraft orders rose 10 per cent in 1994, the first increase since 1988. But the production cycle lags orders by about 18-24 months. As Roger Hurn, chief executive of Smiths Industries, warned last week: "The civil aircraft market will reach its nadir in 1996."

Prospects for R-R's military engine business are more encouraging. The UK's recent purchase of Apache helicopters is helping to bridge a gap between Saudi Arabia's Tornado order and the expected business from Eurofighter - assuming no further delays in the latter.

In the intensely competitive engine market, R-R's two larger rivals, Pratt & Whitney and General Electric, have also cut costs and are generally regarded as being more efficient than their UK competitor.

Stockbroker BZW, perhaps the most pessimistic of the R-R Cassandras, believes further substantial reorganisation may be needed to restore margins. R-R's restructuring provisions have been spent, and further charges - even another rights issue - are on the cards. Closer ties, possibly a merger, with other European engine makers are rumoured, though these would involve short-term costs.

The depth of R-R's problems were underlined in half-time results announced last month. Aerospace profits grew pounds 3m to pounds 46m, but only because they were propped up by a pounds 21m cut in spending on research and development.

Not that things are looking much brighter on the industrial power side, where profits dipped pounds 7m to pounds 30m. They would have crashed without the pounds 23m raised from business disposals.

R-R is a relatively small player in the power sector, and the weak market means the operation has insufficient volumes and is not cost competitive. The division is expanding, particularly in India, but the country has a poor record for profitability.

R-R did not have an executive available to defend the business when approached by the Independent on Sunday, but in the past Sir Ralph Robins, chairman, has said all the gloom is misplaced.

He pointed to the recovery in airline profits, which should help sales. "We believe the civil aircraft market is going to grow and we will get our share of it," he said.

Despite his optimism, the watchwords for investors should be "extreme caution". R-R's history of unstable profits and cash flows may well continue, and another equity injection is possible. With earnings and profits likely to continue to be disappointing, several analysts believe R-R shares should be at a significant discount to the market average price/earnings ratio.

BZW believes that a p/e discount of at least 20 per cent is called for, suggesting a price of under 135p - Friday's closing price was 155p - even if the valuation is extended as far as 1997 earnings.

Nor should investors pin their hopes on a bid. First, a bidder, which would more than likely be one of R-R's few competitors, would come up against the anti-trust authorities. Second, the British Government is thought unlikely to lift foreign ownership restrictions, currently 29.5 per cent.

At the moment, there appears to be little to hold up the company's shares. Sell.

Rolls-Royce

Share price 547p 1994 1995* 1996*

Sales pounds 3.16bn pounds 3.45bn pounds 3.60bn Pre-tax profits pounds 104m pounds 155m pounds 190m Earnings per share 6.86p 9.13p 10.69p Dividend per share 5.0p 5.0p 5.5p Dividend cover 1.4 1.8 1.9 Gross yield 3.7 3.7 4.0

* Estimate