Proactive Investors - Rolls-Royce Holdings PLC (LON:RR.) needs some “near-term pain” or else long-term gains will be very difficult, JP Morgan has warned ahead of final results next month and after Tufan Erginbilgic recently took over as chief executive.
Ex-BP executive Erginbilgic, who took up the CEO reins on New Year's Day, “needs to take some tough and early action” to improve the FTSE 100-listed group’s focus, financial resilience and operational performance, the bank said.
Shares in the maker of engines and small nuclear reactors are over 76% below their peak due to various challenges in recent years but are expected to head even lower as “many more challenges and risks” lie ahead, analyst David Parry wrote in a note to clients on Wednesday.
These include a balance sheet that is still “very weak and needs reinforcing”, with a November update revealing roughly £4bn of drawn debt is outstanding, twinned with £3bn of cash and £5.5bn in undrawn loan facilities.
This was backed up with a reminder that the group operates in “an industry that is vulnerable to shocks” such as end-market downturns and technology issues.
“We think Mr Erginbilgic should reinforce RR’s balance sheet early in his tenure, rather than risk needing to do so during a potential future crisis,” wrote Perry.
In civil aviation, the analyst pointed to “a growing risk that profits disappoint on long-term service agreements” and that Rolls “needs to address major strategic weaknesses”.
Rolls derives 80% of its civil aftermarket revenues from these long-term agreements, where airlines are charged on a price-per-engine flying hour for maintenance, which transfers risk to the engine manufacturer if maintenance costs are higher than expected.
“The latest generation of aero engines offer c15% fuel burn savings but it is now clear that the price of this is shorter time-on-wing and higher maintenance cost,” Parry observed.
For Rolls’ Power Systems arm, the transition from diesel engines to electric power “could be very challenging”, he added, with the division deriving around 90% of sales from diesel engines.
With many end-markets predicted to migrate to hybrid and/or electric power in the coming decade, the analyst queried whether Erginbilgic will decide on investment in electrification – “a nascent industry where technology success is uncertain” or choose either to run the business for cash or seek an early exit.
Other near-term pain may be required in the form of increased investment in new markets where the company has been making relatively small moves in the past year, including electrical propulsion for small aircraft and small nuclear reactors (maybe hydrogen-powered planes too).
These are “likely to prove more costly than expected with no guaranteed returns”.
JP Morgan’s rating on the shares remains ‘underweight’, with a share price target of 70p that compares to a last close at 108.54p.