Jeremy Warner's Outlook: Now even Rolls-Royce takes a battering

GSK's gruesome profits warning; Public accounting for Northern Rock
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The Independent Online

Only profits coming in about 10 times higher than consensus estimates would please the markets in today's spooked environment, but, all the same, it is quite hard to understand the beating taken by the Rolls-Royce share price yesterday on what to me look like spectacularly good results from one of Britain's few remaining world-class companies.

Sir John Rose, the chief executive, must be wondering what he did wrong. Sales and profits were up by 6 and 13 per cent respectively, despite the weak dollar, the currency used for the great bulk of the company's sales.

Cash flow was also positive, even after a £500m pension fund top-up, while the order book has leapt an astonishing 76 per cent to a record £45.9bn. Orders from the Middle East and Asia alone are now worth more than the company's entire order book just four years ago.

So why the punishment? For some reason, the markets had got it into their heads that a review of the aero-engine group's finances would yield a big buy-back or special, one-off, dividend. Instead, Sir John has gone for a step change in regular dividends, which are to be rebased with an increase of some 35 per cent.

Combined with the decision to drop scrip dividends, this is actually a much bigger increase in the effective payout than the markets perhaps appreciate, with the cash handout rising from £100m to £240m. What's more, there's no more of the ongoing dilution that used to occur as a result of the scrip.

Personally, I've always been sceptical about the supposed attractions of buy-backs, which, though obviously very helpful for managements with bonuses riding on earnings-per-share criteria, rarely seem to do much good for the share price. Despite the taxman's take, it is perhaps better to have the money as a dividend.

In any case, the absence of a big, one-off, capital repayment has left some observers wondering if Rolls-Royce is not hoarding its cash in preparation for a calamitous economic downturn, or perhaps some ill-judged M&A adventure. As to the latter, there seems little danger of that, though Sir John is unapologetic in insisting that he will continue to invest heavily in Rolls-Royce's future, as he must with the challenge of climate change added to that of still intense competition.

Yet with high barriers to entry a deterrent even to the Chinese, he is for the time being sitting pretty with the group's strong service and spares business providing a useful buffer against economic recession. The service business, now 55 per cent of sales, has shown consistent double-digit growth right through the cycle.

Even if airlines aren't expanding, they still have to keep the existing fleet flying. The fast growing, resource-rich or industrialising countries of the developing world also have a tremendous appetite for the propulsion and compression systems that complement RR's better known interests in aero-engines. Still, though the shares fell more than 10 per cent yesterday, at least Sir John can comfort himself with the fact that they are still only 20 per cent off their all-time high of about a year ago. There aren't many FTSE 100 stocks that you can say that about.

GSK's gruesome profits warning

Shares in GlaxoSmithKline, by contrast, trade at about half their all-time high, and that was recorded nearly 10 years ago. GSK has never lived up to the high hopes vested in the merger of Glaxo Wellcome with Smith Kline Beecham all that time ago, though it could reasonably be argued that the situation might have been even worse for the two of them had they not merged.

In any case, the problem for the share price has been less in the merger than in the challenges faced by "Big Pharma" in general. Two of these were writ large in yesterday's profits warning.

Sales of Avandia, the company's diabetic drug, have plummeted since the warning last May that, in a small number of cases, it might increase the risk of heart attack. Meanwhile, generic competition is clobbering the sales of older blockbusters as they fall off patent, with mooted replacements still struggling to fill the breach.

It's a pity for Jean-Pierre Garnier to have to mark his last set of annual results as chief executive with a profits warning, for, after a somewhat shaky start, he is generally considered to be leaving the company in better shape than he found it and certainly better prepared for an uncertain future than many of its rivals. His successor, Andrew Witty, enters a much more risk-averse and price-conscious world than the one JP was brought up in.

Yet it is also a world filled with opportunity for transformation. Cutting-edge, prescription drugs have to date been largely an expensive, Western, luxury. Mr Witty's primary challenge is to bring his portfolio of life-enhancing products to the emerging mass markets of Asia and Latin America. In pursuit of these volume opportunities, established and until now jealously guarded pricing structures will go out of the window. The switch from high price/low volume to high volume/low price will either spell the end of Big Pharma, or mark a new beginning.

Public accounting for Northern Rock

Just accounting mumbo-jumbo, or something more serious? On one level, the Office for National Statistics' decision to force the Government to bring Northern Rock's liabilities on to its own books is just a technicality – albeit one with startling repercussions for the letter of Gordon Brown's fiscal rules.

The ONS has ruled that virtually all of Northern Rock's liabilities be categorised as national debt, including not just the £25bn loaned to the Rock through the Bank of England but the roughly £50bn of assets securitised through the special-purpose vehicle, Granite. Together with other liabilities, we can call it a nice round £100bn.

National debt thereby soars to around 45 per cent of GDP, shattering the Government's self-imposed ceiling of 40 per cent. Even before the Northern Rock debacle, this rule was perilously close to being broken. The ONS decision reduces it to pulp.

The purpose of the rule is to act as a corset which constrains the Government's ability to borrow to spend. The Chancellor, Alistair Darling, can reasonably argue that, since these loans and guarantees are likely to be temporary, they should have no implications for fiscal policy.

What's more, all the liabilities are in theory backed by matching assets, which will appear on the other side of the ledger in the national accounts. Even so, it is a monumental embarrassment for the Government, which all along has tried to present these loans not as taxpayers' money put at risk but as just temporary liquidity to a distressed bank.

Now the ONS has gone and categorised the Northern Rock exposure as very much taxpayers' money. And so it should. This is not the same thing as debt guaranteed by the Government, which as with lending to Network Rail has traditionally been treated as a contingent liability and therefore kept off the books. Rather, the ONS has concluded that, since the public sector has the power to control Northern Rock's general corporate policy, its loans should be regarded as public money.

At this stage, the ONS expresses no opinion on how the debts might be accounted for once the loans are refinanced as bonds guaranteed by the Government. The decision will depend crucially on whether the Treasury is still thought to control the company. Whatever the ONS ruling, most people will continue to think of it as taxpayers' money as long as the guarantee persists, as will rivals already complaining loudly of unfair state competition.

In the US, great tranches of mortgage lending are implicitly underwritten by the government through Fanny Mae and Freddie Mac. If you think Northern Rock is bad, just consider the implications of bringing all UK mortgage lending on to the Government's books.