Analysts Upgrade Rolls Royce Despite Scandal

Rolls Royce has settled its bribery and corruption enquiry, and despite short-term headwinds analysts have upgraded the airline manufacturer thanks to currency uplift

Jeffrey Vonk 24 January, 2017 | 10:54AM
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Jeffrey Vonk: A stock which has been, a U.K. stock which has been negatively in the news lately is Rolls Royce (RR.). The announcement was two-days ago that they settled an investigation regarding bribery for £700 million. That was a bribery deal which involved the U.K., the U.S. and also some Brazilian investigation authorities. And it has to do with getting deals done by using middle men, bribery or potential other things which are not that well for the business.

I think if we go back a little bit on Rolls Royce. I think Rolls Royce is from a business model very interesting. They make a lot of, they make engines and the engine business model has a lot to do with safety and specific requirements. Due to those requirements and that safety angle and high cost involved related to building the engines. At most times its two, three player market so relatively benign market environment.

And so they make the engines and the engines are in the air for about 25 years. And you have to do lot of maintenance for that and again coming back to the safety angle you do that always with original provider because you don’t want to pick any risk on safety of lives. So, the engine manufacturers have a very high margin after revenue stream. Just like Rolls Royce.

Unfortunately, currently there are also some short-term issues which are affecting the profitability and also the cash flow generation of Rolls Royce. They are replacing older, they are replacing old high margin engines with new engine models which are new to launch prices and the lack of production volumes, they are sold at a loss. That is affecting their profitability and also the cash generation. That combined with another payment of £700 million makes us skeptical about the cash flow and liquidity of Rolls Royce at this stage. 

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Jeffrey Vonk  is an equity analyst with Morningstar.