Rolls-Royce Thinks Too Highly of Itself
Profit's an opinion, while cash is a fact. If that investor maxim holds true, Rolls-Royce Plc had far too high an opinion of itself in the past. Perhaps it's time shareholders adjusted their view too.
On Wednesday, the British aircraft engine maker gave figures showing that its civil aerospace unit might have made an operating loss last year, instead of an 800 million pound ($996 million) profit, if it had used a different accounting method. Group operating profit would have been about two-fifths of what was reported, plus the balance sheet would have suffered a 3.5 billion pound pre-tax hit. 1 The negative effects from new accounting practices should carry on for several years.
The company wants you to think this doesn't matter much. Over an engine's lifespan, the ultimate level of profit shouldn't change, only the timing of when profit's booked. Cash flow stays the same and that's what counts. It has an argument here. Rolls-Royce relies on cash to pay bills and analysts use it to assess what the business is worth.
While there's more cash going out of Rolls-Royce than coming in -- the outflow could be as much as 300 million pounds in 2016 -- that's expected to change in coming years as it sells more engines for twin-aisle jets.
But while reported profits are an imperfect yardstick, they matter; something I argued when looking at Boeing Co.'s civil aerospace business, which would have reported losses in 2012-2014 had it used the same accounting method as Airbus Group SE.
Besides giving a snapshot of corporate health, investors use profit to compare one company with another. Moreover, if your earnings flatter the true state of affairs, employees might think they don't need to change. New CEO Warren East has been forced to slash costs and managers. Rolls-Royce accounts should have come with a health-warning.
The irony is that Rolls-Royce's civil business isn't very complicated. It sells plane engines and maintenance packages. But its accounting practices are barely comprehensible. It usually makes a cash loss when selling an engine but compensates for that with high-margin service income. But instead of reporting those engine losses via the P&L, it capitalizes them on the balance sheet and pulls forward future maintenance earnings, flattering current margins.
When new accounting rules, called IFRS 15, come into force in 2018, Rolls-Royce won't be able to do that. If it loses money selling an engine, it will have to say so. And it will book service revenues only when an airline sends its plane to the workshop, typically about five years after it's first delivered. The upshot is that profit and cash flow will be better aligned. That's a relief, but for several years reported profit won't be pretty.
Does it matter? Earnings tend to be more volatile in aerospace because technology programs need big upfront investments that sometimes pay off only a decade later. But neither investors nor employees were well served by obscuring that reality. The onus is on Rolls-Royce to spell out why their patience will be rewarded in the long-term. That transparency should aid East's efforts to overhaul the company.
Unfortunately, even after today's attempted clarification, it might be a while before the fog lifts. It would be helpful, for example, if East gave investors more backdated profit numbers. It's planning to report 2017 earnings under existing accounting standards and then restate those results in 2018. That seems bizarre.
Rolls-Royce shares trade at 28 times estimated earnings, about 40 percent more than peers. To someone unfamiliar with its accounting, this might suggest that investors expect earnings to grow rapidly. But it's equally possible that investors have little confidence in those profits. Right now, the second explanation is more likely.
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