Rolls Royce earns a short break from not being complacent

Two years after Rolls-Royce embarked on a root-and-branch revamp, the success of which is increasingly evident, it’s still quite predictable that CEO Warren East cautions that “this is no time for complacency”.

As prudent as East’s admonition is in the face of “in-service issues in Civil Aerospace”, the group’s 51% revenue generator, and others, a 6% rise in underlying revenue in the first half to $6.9bn and underlying pre-tax profit that was 70% above average forecast are orienting investor sentiment more subtly to continuing risks. Rolls-Royce shares traded at a 26-month high on Tuesday morning, up almost 10% on the day, easily their best day of the year.

Shareholders were applying a similarly moderate abstraction to Rolls’ most newsworthy theme of late, the possibility that it might not hit its £1bn cash flow target by 2020. The negative £339m free cash flow result in H1 was after all not as negative as the £585m expected. And now, with restructuring savings ahead of plan, the negative half-year balance is also partly a function of the rise in Rolls’ R&D bill as planned—it increased by almost 9% in H1—whilst the group is doubling production of larger civil aero engines. It’s notable that RR’s underlying operating margin nevertheless expanded 220 basis points to 2.6%.

This all makes the group’s reiterated outlook one of the least credible aspects of its official prospects following the first half—again that is down to management predilection.  The group was no more specific in February than to state that it foresees “modest” improvement in profits, and that free cash flow generation would be similar to 2016 (£973m). Tuesday’s stock market reaction thereby shows investors are attempting to close to the gap between due caution and an almost completely renewed Rolls-Royce that is likely to easily increase profits by more than the low single-digit amount guidance implies.

After the stock’s 34% rise in 2017 up to Monday’s close, and with profitability and cash generation now all-but cemented in a more sustainable footing, similar upside into the second half of the year may still be a big ask, but a significant drift lower is unlikely.