Powerful arguments over Rolls

THE INVESTMENT COLUMN
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Differing views make for a healthy market but rarely is the City as divided as it currently finds itself over Rolls-Royce, the aero engine maker. Brokers have either been strong buyers of the stock for some time now and are feeling pretty smug about the 10 per cent outperformance of the market over the past year, or they are doggedly persisting with long- held bearish views.

The sell argument goes as follows. Rolls' main customers, the airlines, have been so weakened by recession and deregulation that they are having to use equipment longer and more efficiently. That in turn has led to low capacity utilisation at Rolls and its competitors, which has squeezed prices and margins.

Other problems include the increasing reliability of engines, which has cut the importance of spares to the final profit equation. The importance of that issue was highlighted by the sniping surrounding Rolls' recent contract to supply Singapore Airlines with its new Trent engine. A loss leader, cried the opposition; a profitable deal, responded Rolls.

With those sort of low-quality earnings, the bears believe a discount to the rest of the market is appropriate, say 20 per cent, resulting in a share price of less than 150p. As the bulls are glad to point out, however, it hasn't quite worked out that way. Yesterday, the shares closed 4.5p higher at 213p, continuing a strong recent run.

That outperformance reflects Rolls' increasingly strong position in the Far East, which in air traffic as in most things these days is where the action is. Passenger volumes in the Pacific Rim are growing at 10 per cent a year and Rolls claims over 60 per cent of the so-called high thrust (big engine) market.

The company's new Trent engine has a big weight advantage over its rivals, which translates into up to 30 extra revenue-generating passengers per flight. It also has greater potential than other engines in the power generation market, where two engines operating together can create enough power for a town with a population of 10,000.

Recovering military engine sales, largely thanks to Tornado sales to Saudi Arabia, should ensure that profits continue their rapid bounce, reaching perhaps pounds 210m this year and pounds 265m next.

On a prospective price/earnings ratio of 17 falling to 15, the shares are still not overpriced compared with that sort of growth, but they have probably enjoyed the best of their run.

Dawson still feels high street chill

It is very difficult to find anything positive to say about Dawson International, the upmarket jerseys to down-market vests group. In the space of just over two years it has slashed its dividend, written off more than half its shareholders' funds and caused a furore with a pounds 2.2m pay-off for the four directors who presided over this mess. Bruised shareholders who supported the rescue rights issue at 120p in 1994 might have believed that, after this catalogue of disaster, nothing worse could befall Dawson.

They would have been wrong. Yesterday the shares fell another 13p to 98p after the group produced another crop of trading warnings, covering every division of its much-shrunk business. It rounded off the dismal tale by revealing that it has been unable to complete the $13m sale of five of its nine US fleece and jersey plants agreed last July.

The profit warning left analysts slashing around a third off forecasts for the current year ending in March, leaving a figure of around pounds 10m.

It is clear that new chairman Derek Finlay is having more trouble than expected in turning around Dawson. The JE Morgan thermal underwear business in the US is already a long-running sore. Now its main customers, principally Wal-Mart, the giant discount group, are suffering at the hands of sluggish consumer demand.

In the UK, the middle market Pringle knitwear continues to suffer in the face of a high street also reluctant to spend. Similar problems seem to be affecting Dawson's fur fabrics business and are feeding through to the cashmere side.

Given the string of profit warnings from others in the sector and his short tenure at the top, Mr Finlay and his team are likely to be given the benefit of the doubt this time. But a promise to maintain the final dividend will be of little consolation to long-standing shareholders like PDFM, which owns 25 per cent of the company.

The temptation to sell out to the first serious bidder will be strong, unless Dawson can quickly show that its problems are not better solved as part of a bigger group. The shares are well overvalued on a forward multiple above 17, but the brave should hold on for a bid.

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