Rolls-Royce is on a slow flight to recovery

LONDON: A Rolls-Royce performance leaves something to be desired these days. Chief Executive Warren East has managed to arrest the freefall that the engine maker was in when he took over one and a half years ago.

A record 2016 loss of 4.6 billion pounds, caused mainly by non-cash impairments due to the weaker British pound, masks a better-than-expected underlying performance. East beat his 2016 cashflow guidance, cost-cutting plans are ahead of schedule, Rolls' long-haul jet engines are winning market share, and the group's order book covers almost six years of annual sales. But the path to full recovery involves a long haul.

The majority of Rolls' five main business units face headwinds. In civil aviation, which accounts for half of overall group revenue, strong demand for a new generation of jet engines will have a paradoxical impact on profit and cashflow in the medium term.

The Derby-based group sells engines at a loss and generates profit over time by servicing them. Profit and cashflow suffer initially since it takes a few years for the lucrative service revenues to outweigh the initial loss. Meanwhile Rolls' defence business, which generates margins that are almost three times chunkier than the group average, faces restructuring costs and higher spending on research and development.

And despite a rebound in oil prices, the marine business is unlikely to emerge from the doldrums given overcapacity in the sector. Rolls therefore probably has few positive surprises left up its sleeve for 2017.

A stingy dividend policy and unchanged expectations for the medium term indicate the group knows as much. However, investors appear a tad more sanguine. After rising 16 percent in the past year, Rolls shares are trading at around 20 times expected earnings for the next 12 months.

That's a third above the average of the past five years and a quarter above aviation and defence peers, Thomson Reuters Eikon data shows. Keeping the stock stable at such high altitudes will require a flawless performance on the flight deck.