Investment Column: Engine power boosts Rolls-Royce

ICI's dividend rise is not impressive enough; Expanding LA Fitness looks in good shape
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The Independent Online

Rolls-Royce shares have put in a turbo-charged performance since we tipped them a little more than a year ago.

At the time, the engines maker was suffering the worst of the post-11 September slump in orders for new aircraft, and also facing concerns over the size of its pension fund deficit and off-balance sheet liabilities.

Since then, the company has reached agreement with its employees to increase contribtuions to the fund, and the market has grown to more fully understand the potential liabilities, which are highly unlikely to crystallise. Best of all, the chief executive, Sir John Rose, said yesterday that it seems 2003 proved to be the trough year for civil aircraft engine deliveries, not 2004 as he had previously predicted.

The rebound in airline passenger numbers has come ahead of the new planes entering service, so existing planes are flying more, and consequently needing to be serviced more often. In the interim results, posted yesterday, Rolls-Royce boasted a 22 per cent rise in civil aircraft engine maintenance work. The suspicion has long been that Rolls-Royce barely washes its face when it sells an engine, instead making most of its profits on the after-market servicing, so it would have been the increase in maintenance work that helped profitability rebound strongly in the period.

The slide in net debt, from £895m in the first half of 2003 to just £550m in these results, is testament to Rolls-Royce's tight control on working capital. The improved cash flows and a mighty future order book of £19.7bn should give investors confidence that the dividend - which this year is expected to yield 3.4 per cent for an investor buying in today - can be improved over the next few years. The company has guaranteed a stable future through investment in new engines for use on ships and in the power industries, which are starting to produce lucrative orders.

The shares, up 90 per cent since our last note, look worth holding on to.

ICI's dividend rise is not impressive enough

Long-suffering investors in ICI, the chemicals giant, were yesterday rewarded with a dividend rise - the first since 1996. Thanks, then, to John McAdam, the chief executive, who came in last year. Nine months into his turnaround plans, ICI yesterday reported half-year profits up 23 per cent, despite a 6 per cent impact on sales due to adverse currency movements. ICI shares jumped 12 per cent.

It was a solid performance, particularly in Quest, the fragrance and food flavouring unit that hit disaster two years ago. But don't get carried away. Quest only accounts for 10 per cent of ICI's profits and there are bigger issues at stake. The key problem for ICI and its peers is rising raw material costs. ICI is heavily dependent on oil prices, which show no sign of falling. ICI can only pray it can pass these hikes on to its customers. At the moment, increased demand is permitting that, but there is no certainty customers will continue to agree to pay more.

We admit to have been consistently wrong on ICI in this column, at first believing in the recovery too soon, and then being overly critical of its potential. But we will use the dividend as our guide now. Boards usually trumpet dividend hikes, marking them as an indicator of confidence in the future. After "rebasing" (that is, cutting) the dividend in 2001 to a fixed percentage of net profits, yesterday's rise was a matter of technicality rather than confidence. Forecasts for the year put the yield at 3.8 per cent. That's not impressive enough compared with many other cyclical stocks. Avoid.

Expanding LA Fitness looks in good shape

With the Government and even the BBC driving efforts to promote health, fitness and weight loss in Britain, LA Fitness, the only health club chain listed on the stock market, stands to gain.

The 67-site group has been expanding to catch growing customer numbers. Two more clubs were opened in June and are already trading profitably, and membership figures now stand at 200,000, up 21 per cent on a year ago. It has also just announced a three-year contract with the Royal Navy, to test the fitness of its recruits. Defence cuts are on the way and there is little detail on how much this contract will bring to the bottom line, but this is an interesting area to diversify into.

Yesterday's news that UK consumers have racked up £1 trillion of debt might make some reconsider the value of their underused gym memberships. A run in the park is free, after all. But there are still increasing numbers of people for whom going to the gym has become part of their routine.

There will always be a healthy interest from institutional investors to prop up the LA Fitness share price. Fitness First ruled out a bid for its rival earlier this year, but there is always the chance of consolidation, and the stock is not too expensive at 212.5p, on 13 times next year's earnings. Hold.