Share Watch: tough years ahead for Rolls-Royce

  • Rolls-Royce has prosperous future but tough next few years
  • Wynnstay gains stability from diversity
  • XP Power has changed for the better

Each month Richard Beddard trawls through annual corporate results for his Watchlist and the Share Sleuth portfolio of companies that satisfy key valuation metrics such as earnings yield and return on capital - and profiles the most interesting candidates.


If you were to search for a wellspring of technological change, ARM would be a good place to start.

The company designs microprocessors that are manufactured into silicon chips by semiconductor companies and embedded into electronic devices, most notably smartphones.

In the year ending 31 December 2015, ARM earned 22 per cent more revenue than it did in the previous year, and 31 per cent more in adjusted profit. Cash flows were prodigious, return on capital enviable.

It grew market share, incorporating mobile devices and also network infrastructure, servers and embedded devices (the so-called Internet of Things), to 32 per cent. In 2014, its market share was 30 per cent. The year before that it was 28 per cent.

ARM licences microprocessor designs to semiconductor manufacturers for a fee, and earns royalties when they ship chips incorporating ARM-based microprocessors.

A growing number of licences increases revenue now, and future revenue from royalties. ARM signed 173 new licences in 2015 - 10 more than in 2014 - bringing the total number of active licences to 1,348.

A share price of 1,013p values the enterprise at £14 billion, or about 42 times adjusted profit. The earnings yield is 2 per cent. For any normal company, that valuation is preposterously high, but ARM is abnormal.

It's the outsourced research and development partner for much of the global semiconductor manufacturing industry. Its efficient processor designs, already ubiquitous in smartphones, could come to dominate other sectors. That said, smartphone growth is slowing.


The owner of InterContinental, Holiday Inn, Crowne Plaza and other famous hotel brands is in good shape, having sold its hotels.

In full-year results to 31 December 2015, InterContinental achieved a fall in revenue of 3 per cent compared to the previous year, and an increase in adjusted profit of 4 per cent.

The fall in revenue and modest profit growth is not wholly indicative of the company's performance. During the year, it disposed of hotels and other assets worth nearly $1.4 billion (£980 million), including the InterContinental Paris Le Grand, and the InterContinental Hong Kong.

The disposals mark the completion of a programme of hotel sales that will partly pay for a $1.5 billion special dividend if approved by shareholders, and will mean the company has returned £12 billion since 2003.

The business is now a service company. It franchises the brands to hotel owners, and manages hotels for them. It earns 95 per cent of revenue in fees, and in 2015 fee revenue rose 7 per cent.

The company says revenue per available room increased by 4.4 per cent and it added 4.8 per cent more rooms. Worldwide, InterContinental brands account for about three quarters of a million rooms in 5,000 hotels, the majority in the US.

A share price of 2,760p values the enterprise at £7 billion (18 times adjusted profit). The earnings yield is 6 per cent.

While the shares aren't cheap, since it started selling hotels the company has hived off its most profitable business and focused on developing it. A 25 per cent return on capital suggest it's doing a good job.


Rolls-Royce reports underlying pre-tax profit down 12 per cent in the full year to December 2015, although at the operating level adjusted profit rose 7 per cent.

The good news is that Rolls-Royce is still profitable. Return on capital was a healthy 11 per cent, only a fraction below the company's average over the past 10 years, although that estimate excludes various one-off costs.

Chief executive Warren East says most of Rolls-Royce's markets are steady, but it must tackle the weak oil and gas market (which affects its marine division) while investing heavily in civil aerospace.

In the marine division, Rolls-Royce experienced a 16 per cent drop in revenue and a 94 per cent fall in profit due to low demand and restructuring costs.

Civil aerospace is Rolls-Royce's biggest division and strategically it's most important since. With GE, Rolls-Royce operates in a virtual duopoly supplying wide-body jet engines.

The company must invest to increase engine building capacity and meet demand for new engines such as the Trent 7000 and XWB-97.

These engines will earn a stream of profit for Rolls-Royce for decades through TotalCare service contracts, but the cost of preparing the engines and factories for production and delayed recognition of profit in the accounts will impact financial performance over the next few years.

The impending introduction of new engines in 2017 and 2018 is also reducing demand for the older, less efficient engines they will replace.

Due to its reputation, engineering expertise and dominant position in segments of the aero-engine market, the company probably has a prosperous future, but the next few years will be tough and the company's accounting is extremely complicated.

A share price of 683p values the enterprise at over £16 billion, or 12 times adjusted profit. The earnings yield is 8 per cent. That's probably good value, but adding Rolls-Royce shares at this level would be a triumph of faith in the business over uncertain accounting numbers.


Wynnstay's share price has lost a lot of the froth that stopped it being an attractive investment. The company says the growing global population and increasing emphasis on self-sufficiency drive demand for food, but downward pressure on prices requires efficiency gains.

Either way, the company profits. Full-year results for the year to October 2015 show the second factor - downward pressure on food prices caused in part by high global stocks of food - is weighing on UK agriculture, and therefore efficiency rather than rising prices is driving profitability.

Wynnstay manufactures, processes and distributes feed, fertiliser, seed and raw materials for farmers, as well as retailing them through a chain of country stores. It also operates the Just for Pets chain of pet shops.

The company increased adjusted profit 5 per cent compared to the same period in 2014, on revenues that were 9 per cent lower (mostly due to lower commodity prices rather than lower volumes).

Despite a number of small acquisitions, it finished the year with relatively insignificant borrowings and net cash.

Stability comes from diversity - Wynnstay supplies arable, dairy and meat farms - and efficiency comes from scale, with the company expanding into central and eastern England.

A share price of 460p values the enterprise at £115 million, or about 15 times adjusted earnings. The earnings yield is 7 per cent. It's a reasonable price to pay for stability.


XP Power's results confirm the business's decade-long transformation. In the year to December 2015, XP Power earned 9 per cent more revenue and 4 per cent more profit than it did in 2014, although much of the improvement was due to currency fluctuations.

Weak growth in its biggest market, the US, was compensated for by strong growth in Asia and Europe. It anticipates revenue growth in 2016. The company has also increased borrowings modestly to make two small acquisitions.

XP, which has an enterprise value of over £300 million, acquired EMCO for £7 million. It says the opportunity to sell EMCO's products through its presumably much larger sales operation makes the acquisition a significant growth opportunity.

US-based EMCO manufactures high voltage DC (direct current) power supplies.

It's a new niche for XP, which specialises in power adaptors that convert mains AC (alternating current) to DC for the same markets. The second acquisition was a 51 per cent stake in a South Korean distributor. It customises power supplies, including XP's, for equipment manufacturers.

A share price of 1,606p values the enterprise at £324 million, about 16 times adjusted profit. The earnings yield is 6 per cent. XP trades on a fairly full valuation, but the company has changed the way it does business over more than a decade.

Originally a distributor, today it designs and manufactures the majority of its products. Customers, who commit to including XP adapters in their products for many years, seem to like those products better. The result is high returns on capital and strong cash flow.

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