Stock of the Day: Roll-Royce could lose thrust if dividend disappoints

More cash flow, higher dividends – that’s how it normally works.

Stock of the Day: Roll-Royce could lose thrust if dividend disappoints

More cash flow, higher dividends – that’s how it normally works. But Britain’s most inveterate aero engine maker will pay investors a total of 11.7 pence per share for the 2017 financial year, the same as the year before.

Last February Chairman Ian Davis noted: “The investment needs of the business remain high, reflected in the low level of free cash flow in 2016 and this is expected again in 2017.”  Those cash expectations were admirably conservative. Free cash flow surged 173% to £273m in 2017, more than twice the sum investors were expecting. CEO Warren East expects £450m in 2018. That’s despite the impact of Trent 900 and Trent 1000 remediation that is forecast to double to £340m. Higher margin contracts on newer engines with more flying hours and operating margins that have steadily improved since East joined in 2015 are set to offset Trent issues. Capex is anticipated to be steady, net R&D to inch higher, core Defence contracts in the U.S. were renewed, whilst Power Systems cost reduction is virtually complete.

The group is not guaranteed to achieve its £1bn free cash flow target by 2020. But the goal is now more credible. In the meantime, an unchanged 2018 dividend would reduce the payout to about 50% of cash flow from about 80% in 2017. Such a cut would jar with Rolls’ rapidly improving financial health. Investors sent the shares up 11.5% on Wednesday expecting a conventional response from Rolls to rising free cash flow. If optimism turns out to be misplaced, an Investor Day scheduled in June may bring the first warning.

Thoughts on Rolls-Royce’s share price chart

Rolls-Royce shares are eyeing another attempt to surpass cycle highs between 998p and 1015p that have been the limit for all upward range expansions for over four years. The most recent failure at or near similar peaks were last July and November. Two years before that though, Rolls tested what turned out to be, at the time, a four-year low, and began to advance on a rising line that remains intact to date. The line is likely to survive any slippage should the shares fade to fill the huge gap that opened whilst vaulting as much as 13% on Wednesday. The stock has in fact mostly held above 820p since last year so may not even tag the trend line. In any case it probably needs to stay top side, for chances of an eventual break above 1000p to remain more than evens.

Rolls Royce Holdings Plc. share price chart – daily intervals

Source: Thomson Reuters and City Index

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