The Investment Column: Rolls-Royce powers ahead

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WITHIN THE space of three years, Rolls-Royce has gone from producing around 400 engines for the civil aviation market a year to over a thousand. Indeed, deliveries are so strong that they will hold flat next year. But there are drawbacks to the company's success.

The rise in output has also seen the group's working capital grow to pounds 575m, and the group's net debt hit pounds 325m. The shares have been in decline since they almost touched their all-time high of 304.5p in June; the City's concerns over the group's cash outflow saw the shares fall 8.5p yesterday to 248.25p.

The fall came even though chief executive John Rose said the group would be cash positive by the year-end, and again committed the group to achieving double-digit earnings growth. His confidence appears justified. The group has about 20 per cent of the civil aviation engines market, and 30 per cent of present orders.

The civil aviation market - responsible for half of group sales - is tough, and some analysts perceive a risk of a downturn. Last month Roll- Royce took a blow when Boeing awarded the contract to supply engines for its new B777 planes to GE. But Rolls-Royce sees other opportunities in the civil market. While Rolls-Royce expects fewer juicy orders for engines for large planes, engines for smaller jets are in demand because propeller- based planes are declining in popularity.

The company is also to supply 140 engines for the B777's rival, the Airbus A340, in the next three years, in orders worth $5bn. The large-engine market is not completely dead either, with a recovered Asia expected to generate orders. Rolls-Royce's defence arm is set to supply both the Eurofighter and the Boeing/Lockheed joint strike fighter.

All this adds up to an order book of pounds 10.3bn. The group, which saw continuing sales rise 6 per cent to pounds 2.10bn in the half year, is investing 5 per cent of sales in R&D and spent over pounds 100m on capital expenditure in the half year. Much of that investment is going into applying its expertise in gas turbines in the energy sector, responsible for less than a fifth of sales. It recently bought out a joint venture and plans further expansion. A cost-cutting programme should save pounds 70m this year.

The problem for investors is that the real rewards come much later, in the form of aftersales servicing and spares contracts, which account for 38 per cent of sales, up from 35 per cent at the year-end. That will take time. But Rolls-Royce was always going to be a long-term bet.

Analysts forecast pre-tax profits of around pounds 365m this year and earnings of 18.6p per share, rising to pounds 423m and 20.9p in 2000, putting the shares on a forward p/e of 13. Despite the present cash outflow, Rolls-Royce remains a strong hold.