Shares in Rolls-Royce (LSE: RR) are surging this morning after the company announced that it had reached a settlement with bribery investigators in the UK, US and Brazil who have been investigating the company since 2013. The settlement removes an enormous dark cloud that has been hanging over the company since that time.
However, while the deal has been welcomed by shareholders the financial penalty imposed on the company is larger than even the most bearish analysts were expecting. Indeed, Rolls has agreed to pay £671m to settle investigations. When you consider the fact that analysts were expecting RR to report a pre-tax profit of £668m for 2016, this penalty seems extremely severe.
Nonetheless, the market seems pleased with this settlement as it removes a certain amount of uncertainty hanging over the group and as the penalty is expected to be paid over the next five years, the financial impact will be limited.
What’s more, Rolls also announced after the close yesterday that the company’s 2016 profit will beat expectations. This is great news for long-suffering shareholders. For the past two years, Rolls has lurched from profit warning to profit warning, but it seems that the restructuring efforts of CEO Warren East, who was brought in to stabilise it in mid-2015, are now starting to pay off.
A reason to celebrate?
Even though the market seems pleased with the settlement and upgraded profit forecast, the company’s outlook remains uncertain.
The deal with the three authorities investigating the business will see the group pay £293m of the total fine in its first year, which is still a substantial amount.
Further, even though Rolls is set to beat 2016 City expectations for growth this year, analysts have expressed some serious concerns about its ability to generate future profit after new accounting rules come in during 2018 that will force it to change how it recognises revenue. According to Rolls’ own calculations, the new accounting standards would have reduced 2015 profitability by £700m, almost 100% of the group’s normalised profit.
Still, despite these accounting changes it does appear to be on the right path to recovery. City analysts are expecting a 61% fall in earnings per share this year (although these figures are likely to be revised higher following yesterday’s positive trading update) before rebounding 45% during 2017. As of yet, it’s not entirely clear how the company will do when new accounting standards come into place during 2018. Based on current forecasts shares in the group currently trade at a 2017 forward P/E of 19.5.
The bottom line
All in all, the bribery settlement has removed some uncertainty from the company’s outlook although the business still has some way to go before it can claim to have fully recovered from past mistakes. The £671m fine may be spread over five years, but such a hefty financial penalty is the last thing the company needs when profitability is under pressure. As the payment of the penalty is spread over five years it doesn’t make Rolls entirely uninvestable but any further bad news from the company could send the shares tumbling.
