Rolls Royce shares stall after second warning in four months

Updated 1205 pm

Rolls-Royce Holdings Plc. the civil, defence and aerospace engine manufacturer announced its second profit warning in the space of four months sending its shares sharply lower.

The second-largest manufacturer of aircraft engines in the world reported 2014 profit in line with guidance, but it downgraded expectations for this year citing the deterioration of economic conditions for customers in the oil and gas markets.

This downgrade of already downgraded forecasts is likely to further undermine investor confidence in the venerable British company, which up to last year had enjoyed 11 years of strong profit and revenue growth, amid demand for fuel-efficient passenger jet engines.

Guidance cut, and cut again

Rolls-Royce is today cutting 2015 forecasts it issued in October, having shocked the market at the time by warning there would be no growth this year.

Underlying pre-tax profit of £1.6bn for 2014 is 8% lower than last year, but in line with guidance for profit to be flat excluding £150m currency effects and one-off charges.

RR now sees underlying profit for the current year between £1.4bn and £1.55bn, as much as 14% lower than its October 2014 forecast.

It looks like a consensus forecast compiled by Thomson Reuters from polls of institutional analysts, before today’s outlook cut, targeted profit around the mid-point of the range provided by Rolls, calling for £ 1.481bn.

CEO cites “growing uncertainty”, market reacts in kind

The alignment of market forecasts with the median of guidance may help explain why Rolls Royce’s stock tumbled 3.3% lower after the market opened on Friday, only to recoup, and then veer between moderate gains and moderate losses as this article was updated a number of times up to the late morning.

The stock market may also be giving Rolls’ management some additional leeway because the company this morning predicated its faltering profit outlook partly on the struggling oil and gas sectors, for the first time.

However, later, I suspect the market may weigh comments from the company’s CEO which from my reading, appear to place the balance of probabilities for the 2015 outlook on the more pessimistic side.

Rolls’ profit forecasts have gone from seeing a bottom line that was unchanged-to-3%-lower than 2014, to now forecasting profit will be between 4%-to-14% lower.

“We’ve broadened that band because of our growing uncertainty,” said Rolls’ CEO John Rishton during a conference call with reporters this morning.

That needs to be balanced with Rolls this morning stating its order book has hit a record, now worth £73.7bn.

Margin management requires mechanical precision

Still, promising longer-term prospects may not distract investors greatly from Rolls-Royce’s nearer-term challenges—including the need to reposition itself with greater emphasis on its civil aero engine business as defence spending is trending downwards.

To do that, it will need to ramp up production to WWII levels, whilst at the same time keeping a close eye on margins.

That increased vigilance would come after Rolls in June 2014 reported an operating margin of just 7.4%, its weakest in ten years.

The RR balance sheet is stronger than the average of its peer group, with total debt slightly more than a third of its market value against above 50% at most rivals.

But interest cover at 2.4 times underscores that Rolls Royce is indeed entering a tighter spot than it’s faced for at least ten years, and its margin for error is now much more limited.

Rolls-Royce Holdings, which produced its first aero engine in Derby, in the Northeast of England in 1915, will need to harness the mechanical precision and ingenuity that have made it famous, to successfully navigate the tightened straits ahead.

Turbulence in the wind tunnel

Under these circumstances, it’s little wonder RR’s share price looks precariously balanced at current levels.

The stock is barely winning a duel with its 100-day moving average, whilst its rickety descent in the channel from the latter part of 2013 looks likely to continue for the medium term at least.

Sentiment on City Index’s Rolls-Royce Daily Funded Trade, in a half-hourly view, looks as split as the market in the underlying stock.

With nearby support already breached this morning, a descending trend from two days ago overhead, and a still bearish MACD system, continued tests of support seem likelier than tests of near-term highs.