THE INVESTMENT COLUMN
Rolls-Royce is back in the dog house. As signs were appearing that the market for its aero-engines is reviving from one of the longest recessions, it is now evident that the industrial and marine gas turbine operation is facing an unexpected cyclical downturn.
Combined with that, last November's $525m deal to buy Allison, a US aero- engine builder, is not looking so clever after Rolls revealed that it is writing off pounds 324m in goodwill from the cost of the acquisition.
This dismal prognosis is not immediately apparent from yesterday's interim figures, which show a seemingly healthy rise in pre-tax profits from pounds 40m to pounds 70m in the first six months to June. But stripping out gains of pounds 23m from disposals from the industrial power division, the underlying figure of pounds 47m was well below analysts' expectations, sending the shares sliding 15p to 175.5p.
The main problem on the trading front lay in the industrial power division. An important prop to the group's results for the past five years, profits in the latest period crashed from pounds 37m to just pounds 7m, ahead of interest and the disposal gains. The figures had to bear the pounds 7m cost of restructuring and a pounds 4m increase in development expenditure, but the underlying picture remains gloomy.
For some time, a lack of orders at home and fierce competition abroad have dogged the power engineering side, which makes power station and electrical distribution equipment. More of a surprise was a sudden downturn in the industrial and marine gas turbines business, a steady earner that has been hit by delays in picking up big contracts and a fall in spares sales to oil industry customers. It looks poised to remain in the doldrum until next year, when large orders start to bear fruit.
Meanwhile, some of the shine has been rubbed off the Allison deal by news that Rolls is writing $175m off a problem contract. It is also taking full advantage of accounting rules by taking the charge as a fair value adjustment. With a $50m charge against plant and equipment, the contract write-down has allowed Rolls to slash the value of Allison's assets from $250m to just $29m.
That led to the massive goodwill write-off and will shield future profits from contractual losses.
All is not what it seems in the aero-engine side, either. Soaring profits before interest, up from pounds 3m to pounds 46m, mainly reflected a pounds 30m cut in development spending on the aerospace version of the Trent engine and a pounds 9m first- time contribution from Allison. The much-trumpeted bonanza from sales of spares has yet to show through and profits are still not benefiting from the upturn in civil engine sales.
Pre-tax profits of around pounds 147m this year would put the shares on a prospective multiple in the low 20s. That fully discounts a recovery which seems to get no nearer.
Reckitt clouded by L&F takeover
Reckitt & Colman's half-year figures were always going to be clouded by the flurry of corporate activity over the past year. Since last September the company has spent pounds 1bn acquiring the American household products group L&F, in a deal part-funded by a pounds 116m rights issue and the sale of its Colman's of Norwich food business to Unilever.
Disposal gains, including pounds 250m from the Colman's sale, boosted pre-tax profits for the six months to June from pounds 123m last year to pounds 316m.
Reckitt's strategy is to strip away non-core businesses to concentrate on household products. The thinking is that cleaning brands such as Dettol and L&F's Lysol - and even the US company's d-Con rat killer product - are more internationally marketable than food names such as Colman's English mustard. The hope is that Reckitt's increased muscle in the all-important American market will enable it to compete more effectively with the likes of Unilever, Procter & Gamble and Colgate-Palmolive.
Thus far, the transition from disparate conglomerate to focused cleaning giant is going well, although there have been one or two hitches.
On the positive side, L&F's sales, marketing and administration functions have been integrated with Reckitt's. The number of factories has been reduced from eight to four and the unwanted parts of the business are in the process of being sold. L&F sales are up by more than 10 per cent, driven by new products, and cost savings are starting to come through. There will be a pounds 10m gain this year and a further pounds 25m expected by the end of 1997.
The downside is that integration is causing initial disruption and margins have fallen since last year. Profits are also flat, with strong performances in Europe and Asia offset by downturns in Mexico and Australia.
But the outlook is improving. The rationalisation of the European business is pushing ahead and there is still around pounds 150m to come from the disposal of unwanted businesses which should be completed by next year.
Reckitt's shares have drifted up with the market this year. Short-term prospects look unexciting, but the real story should emerge in 1996-97 when the L&F business is fully integrated. BZW is forecasting profits of pounds 290m for this year. With the shares down 23p yesterday to 666p, they are on an undemanding forward rating of 15.
Following Wilson Bowden's recent profits warning, the only real surprise about yesterday's gloomy remarks from Persimmon, the housebuilder, was the extent to which they appeared to catch the market on the hop. The shares, which have already fallen from a high of 376p at the beginning of last year, tumbled a further 17p to 175p as analysts took the red pen to their previous forecasts.
Six months ago, after a good start to the year and optimistic noises from the company, analysts were expecting sales of about 4,000 houses in 1995 to translate into pre-tax profits of pounds 32m. Yesterday they had revised down their expectations to 3,600 completions, at lower margins, for pre-tax profits of only pounds 22m.
Persimmon's problem will soon be a familiar refrain as the building sector's reporting season gets under way. Buyers are streaming through the showhouses, but holding back from doing deals. Persimmon says the market deteriorated progressively from about mid-May. In the six months to June, that led to a decline in pre-tax profits from pounds 11.3m to pounds 10.2m, but plainly the full impact is yet to show through. Earnings per share of 5.8p (7p) covered the maintained interim dividend of 3p less than twice.
After the downgrades, Persimmon's shares are on a prospective multiple of 12.5 times 1996 earnings against an average price-earnings ratio of 12.7 for the market and 11 for the sector.
Arguably, given the continuing pressure on margins from rising input costs and flat selling prices and the changed nature of the whole housing market, the sector's shares should trade on at least a 15 per cent discount to the market. That suggests the shares have perhaps 13 per cent or so still to fall.
The only prop is a chunky dividend yield of almost 7 per cent, assuming the payout is maintained at the full year. Even if it is, the shares are still expensive.
Turnover pounds Pre-tax pounds EPS Dividend
Cairn Energy (I) 5.15m (8.4m) 7.1m (616,000) 7.86p (0.64p) - (-)
Country Gardens (I) 13.3m (10.6m) 1.3m (1m) 6.9p (5.8p) - ( -)
EBC Group (I) 28m (28.2m) 371,000 (356,000) 2.09p (1.8p) 1p (1.75p)
Gibbs & Dandy 13.4m (11.9m) 478,000 (425,000) 4.2p (4.6p) 1.4p (1.2p)
Ladbroke Group (I) 2.13bn (2.29bn) 59.8m (51.9m) 3.47p (2.75p) 2.4p (2.4p)
Macfarlane Group (I) 79.9m (52.5m) 10.1m (7.1m) 5.6p (4.09p) 1.4p (1.13p)
Persimmon (I) 115m (91.3m) 10.2m (11.3m) 5.8p (7p) 3p (3p)
Reckitt & Colman (I) 1.19bn (1.05bn) 316.4m (123.3m) 63.11p (21.53p) 7.35p (6.86p)
Rolls-Royce (I) 1.61bn (1.5bn) 70m (40m) 4.32p (2.51p) 2p (2p)
Silvermines (I) 26.6m (19.6m) 1.3m (700,000) 1.63p (1.19p) 0.3p (0.24p)
Verity Group (F) 34.5m (24.1m) 2m (1m) 0.71p (0.37p) 0.1p (-)
Westport Group (F) 13.4m (14.3m) 41,000 (-448,000) 0.03p (-0.4p) - (-)
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