A Rolls-Royce Reality Check

An accounting change will leave the industrial giant with a tech company's valuation.

What does a capital-intensive maker of aircraft engines with a penchant for profit warnings have in common with fast-growing technology businesses like Netflix Inc. or Amazon.com Inc.?

Not much. And that's why Rolls-Royce Plc shareholders have a problem.

The British company warned this week that profit from its civil aerospace business will be far lower under new accounting standards that will be applied from 2018. You can read a more comprehensive explanation of those rules and their impact here. The question now is what this means for the company's valuation in future.

Rolls-Royce already trades at a premium to peers before the new accounting standards are applied -- a stretch for a company that has warned on profits five times in recent years. 

But adjusting Rolls-Royce's expected earnings to reflect the new way it will recognize revenue puts the company's shares on a forward price-earnings multiple normally accorded only to rapidly expanding tech companies.  1

Reality Check

Rolls-Royce's adjusted earnings trade on a similar forward multiple to Netflix and Amazon

Source: Bloomberg and Gadfly calculations

Methodology: Rolls-Royce's 2015 operating profit would have been 917 million pounds lower had IFRS 15 accounting rules been applied. We've assumed this accounting-related profit headwind will decline by 100 million pounds a year until 2018. By taxing that amount and applying a haircut to the consensus earnings per share forecast, we deduced a new 2018 price-earnings multiple for Rolls-Royce.

Rolls-Royce wants investors to focus on cashflow not profit. But there's no guarantee they will, and it seems unreasonable to demand that shareholders simply ignore a widely-used valuation metric.

The dampener the accounting change will have on profit won't dissipate for almost a decade, requiring more patience than even long-term minded aerospace investors might be willing to provide.

Anyway, Rolls-Royce's cashflows aren't much to boast about either. This year, the business may burn as much as 300 million pounds ($373 million) of cash. That outflow may stop next year, the company hopes.

There's a risk, then, that the huge gap between Rolls-Royce's forward earnings multiple and its aerospace peers will cause the shares to re-rate.

Slow Descent

Rolls-Royce shares fell over two days as investors digested the impact of the accounting change

Source: Bloomberg

Intraday times are displayed in ET.

After declining only 2 percent on Wednesday, when Rolls-Royce first revealed the full extent of its accounting change at a capital markets day, the stock tumbled a further 5.4 percent on Thursday as investors digested the news.

Rolls-Royce doesn't have an online retailing, cloud computing or consumer technology franchise that's likely to dominate the future. It's legitimate to ask whether it should be valued like companies that do.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. Methodology: Rolls-Royce's 2015 profit would have been 917 million pounds lower had IFRS 15 accounting rules been applied. We've assumed these accounting-related profit headwinds will decline by 100 million pounds a year until 2018. By taxing those amounts and applying the resulting haircut to the consensus net income and earnings per share forecast, we deduced new forward price-earnings multiples for Rolls-Royce.

To contact the author of this story:
Chris Bryant in Frankfurt at cbryant32@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net

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