Upgrade to Neutral; many headwinds remain but news flow over next six months is biased to the positive
next several years. Our 2016-18E EPS are little changed, moving 0.3% / 4.0%
/ 3.4% (Table 1). However, we upgrade to Neutral (OW) for several reasons
discussed below. We increase our Dec-16 price target to 690p from 395p. We
now value the stock by applying a target P/E multiple of 16x to our 2020E
EPS of c59p (previously we used our 2017E EPS), discounted back 4 years.
No profit warning last week and no warning likely in next six months:
We expected RR to cut its guidance last week due to growing macro
headwinds across the group. However, management said that it has been
more prudent with its November 2015 guidance than we had thought. We
cannot rule out further EPS downgrades if macro conditions deteriorate,
and/or certain industry trends deteriorate (eg. the number of parked RR aero
engines increases); but this looks much less likely in the next six months.
Mindset of many investors has changed: RR clearly looks very expensive
based on its depressed earnings in the next several years. However, many
investors now seem willing to value RR on potentially much higher profits
towards the end of this decade / early next decade. RR may or may not
achieve this but we struggle to go against this more positive sentiment.
New management making improvements: Financial disclosure has
improved. Communications with investors/analysts have also improved. A
new cost reduction plan is in place; however, we think much greater cost
reduction is needed if RR is to achieve its 2020-2025 profit targets.
New accounting rule could result in higher reported profit: RR could
implement the new IFRS 15 rule on revenue recognition in 2017. CFO
David Smith says his main goal from any accounting changes would be to
make RR simpler for investors to understand. One option could be to write
off at least a portion of the engine losses / “pulled forward profit” that RR
has previously capitalised, so that this would no longer need to be amortised
against future aftermarket profits. A side effect of this simplification would
be to allow RR to report higher future EBITA margins. This happened with
risk-revenue sharing partners when RR implemented IFRS in 2004-2005.