Rolls-Royce can make great engines but when will it ever make good money?

At first glance Rolls-Royce appears to be a great British success story. Over the past two decades the engine maker has evolved from an also-ran into the second largest manufacturer of aircraft engines in the world. Like the European aeroplane maker Airbus, it has muscled in on the stronghold of dominant US competitors and become a formidable force in the aerospace industry.

At the beginning of the 1980s, Rolls had a measly 9 per cent of the market for making aero engines and the un- doubted leader was the US's Pratt & Whitney, which had about 90 per cent. Now Rolls has 31 per cent of the market and Pratt has 14 per cent (according to Rolls's figures).

Some of the credit for this can be given to the chairman, Sir Ralph Robins, who joined the company in 1955, when it still owned the business that made the luxury cars. He will retire next year. But the success of the products camouflages a financial history that is anything but.

Thursday's half-year results announcement is unlikely to do anything to alter the trend, with underlying profits expected to be down 12 per cent, according to Goldman Sachs.

"Rolls is a successful company but not a successful investment," says one analyst. The shares are now at 128p, which is well below the 170p at which the Thatcher government sold when the firm was privatised in 1987.

Rolls is partly a victim of the climate after the Enron and WorldCom scandals. Methods of accounting used to seem dull, but they are now hotly debated and scrutinised. At Rolls there are a number of questioned practices, such as including controversial government grants as profits rather than debts in its accounts.

Research from UBS Warburg says that if more prudent methods of accounting were used, last year's profits would have been £111m rather than the reported £192m.

The other dark cloud hovering over the company comes from the economic situation in the aerospace industry. Rolls's customers, the airlines and aircraft makers, have been in a parlous financial state since 11 September.

Several airlines have gone into bankruptcy, including US Airways last week. On Tuesday, American Airlines said it would reduce capacity by 9 per cent and sack 7,000 people. This could directly affect Rolls's bottom line. American will retire 73 Fokker 100s that are powered by Rolls-Royce engines.

In the worst-case scenario, if no other airline wants to buy them, the loss of maintenance and repair contracts could cost Rolls £20m a year, according to UBS Warburg.

"One of the fears is that more airlines will need to restructure and we will get more of this happening," says UBS's Colin Crook. "Rolls started with a much stronger position at the beginning of the last downturn, it then had cash, now it has debt. There is a risk that it will require further finance in the long term."

Another potential time bomb looms, in the form of the highly topical pension-fund deficit. As stockmarket performance is so poor, pension funds that invested heavily in shares in the 1990s find that they have lost money. The difference between the pension funds and what Rolls will have to pay its staff, including the 5,000 it has sacked over the past year, is about £1bn. Rolls could be forced to fill the hole with its own money.

But some analysts think that the doom-mongers are overlooking an important fact. Rolls has only become a successful manufacturer in the past 15 years. But it takes time to see the financial fruits of the engineering labours. Engines are sold at a loss, and profits are generated from tying the customer to contracts to repair and maintain the engines. A new engine will not need this service for more than five years. Rolls admits that none of the nine engines it has developed over the past decade have yet broken even. But because its engines are relatively young, they are less likely to be retired.

"Any planes withdrawn from service dent the growth profile, but Rolls has a relatively young fleet of engines so it may suffer less than others," says Andrew Thompson, an analyst at Dresdner Kleinwort Wasserstein.

Rolls has a lot to prove. Harald Hendrikse, an analyst at Crédit Suisse First Boston, predicts that returns should come through in 2003.

"But everybody has been waiting for so long that not many people find this credible," he says.

Rolls is currently searching for a new chairman, to replace Sir Ralph, and a new finance director, as Paul Heiden is going to pastures new. Perhaps the new blood will be able to wipe the slate clean, or perhaps investors' patience has just been stretched to the limit.