Analyst: Rolls-Royce’s new CEO must inflict “near-term pain” to have a chance of making long-term gains

Rolls-Royce Holdings PLC LSE:RR. Needs some “near-term pain” to ensure long-term gains, JP Morgan warned. This warning comes ahead of final results next month. It was made after Tufan Erginbilgic took over as chief executive.

The bank stated that Erginbilgic (ex-BP executive) took over the CEO role on New Year’s Day. “He needs to take some tough but early action” in order to improve the FTSE 100-listed company’s focus, financial resilience, and operational performance.

Analyst David Parry told clients Wednesday that shares in the maker and small-scale nuclear reactors company are now 76% below their peak. However, they are likely to fall further as there are “many more risks and challenges” ahead.

These include a balance that is “very weak” and requires strengthening. A November update revealed that approximately £4bn in drawn debt remains unpaid, along with £3bn cash and £5.5bn undrawn loans facilities.

The group’s operations are in an industry that is susceptible to shocks such as technology problems and end-market declines.

Perry wrote that “We believe Mr Erginbilgic should strengthen RR’s balance sheets early in his tenure, instead of risking needing to do it during a future crisis.”

The analyst said that civil aviation was at “a rising risk of profits degrading on long-term services agreements” and that Rolls needed to address “major strategic weaknesses”.

Rolls gets 80% of its civil aftermarket revenue from these long-term contracts, in which airlines pay a price per engine flying hour for maintenance. This transfers risk to the engine manufacturer, if maintenance costs rise beyond what was expected.

Parry noted that although the latest generation of aeroengines offers c15% fuel savings, it is now evident that their maintenance costs are higher and have a shorter life-on-wing.

The transition from diesel engines into electric power could prove difficult for the Rolls’ Power Systems division, he said. Around 90% of the company’s sales are from diesel engines.

The analyst asked Erginbilgic if he would invest in electrification, a “nascent industry in which technology success is uncertain”, or if he would choose to either run the business for cash and/or seek an early exit.

Another short-term pain could be caused by increased investments in markets where the company has made relatively little in the last year. This includes electrical propulsion for small planes and small nuclear reactors (or hydrogen-powered planes).

These can be more expensive than anticipated and have no guaranteed returns.

JP Morgan’s rating for the shares is ‘underweight’. The share price target for 70p compares to 108.54p at the last close.

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