On July 31, 2014, Rolls Royce (OTCPK:RYCEY) (RR.L) reported its first half results. Underlying profit before tax fell 20% on the same period last year, to £644 million ($1.09 billion). As expected, shrinking defence spending and a struggling marine business had more than offset growth in the civil aerospace and energy businesses. Underlying revenue fell 7% to £6.84 billion ($11.6 billion). On balance, the company's first half results have exceeded analysts' expectations, despite the appreciating pound. The company had also reaffirmed its guidance for revenue and profit to be broadly flat (excluding the impact of exchange rate movements) in 2014. Despite this, investors remained concerned about the continued impact of cuts in defense spending and whether profit growth would return as early as 2015.
Earlier in May, Rolls Royce announced the sale of part of its energy business to Siemens (OTCPK:SIEGY) for £785 million ($1.33 billion). Siemens will pay an additional £200 million ($338 million) for a 25 year licensing deal for access to the relevant intellectual property from Rolls Royce. The business is estimated to have contributed around £900 million ($1.52 billion) in revenue and £60 million ($101 million) in underlying profit before tax. With strong demand in Rolls Royce's small and medium sized gas turbines, particularly in the decentralized power generation and oil and gas sectors, profit growth in the energy business would have been expected to be in the high double-digits in the coming years. Nevertheless, Rolls Royce had long struggled to gain the necessary scale to gain a strong competitive foothold in the industry. Siemens, which generates €26.6 billion ($35.6 billion) from its energy business, is in a much stronger position to take advantage of future growth opportunities, and can therefore afford to pay such a premium on the business. Rolls Royce had pledged to buy back £1 billion ($1.69 billion) of its own shares with the proceeds of the sale.
Shares in Rolls Royce have remained weak on continued concerns of weak profitability expected in the near future. The sale of part of its fast growing energy business would certainly have a negative impact on the recovery in profitability in the short- to medium-term. Although Rolls Royce have not offered fresh guidance on revenue and profitability, we can expect downward revisions in analysts' expectations of revenue and earnings for 2015. Nevertheless, with very robust demand in civil aerospace division, which is by far the largest contributor in profitability, I remain optimistic in the company's medium- to long-term outlook (see my previous article, "Rolls Royce: Robust Demand From Civil Aerospace Will Offset Declining Defense Spending"). However it is important to remain cautious as there are few potential catalysts in the near term.
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