Broker tips: Rolls-Royce, Standard Chartered, Pearson, RBS

Goldman Sachs has upgraded aerospace and defence group Rolls-Royce to ‘buy’ from 'neutral', lifting the price target to 1,030p from 743p and adding the stock to its ‘Conviction’ list, saying the company has the potential to substantially increase free cash flow between now and 2020.

The bank noted cash performance at Rolls-Royce has been disappointing as underlying earnings performance has fallen and the investment burden has risen.

It argued that the diversified nature of the group and the impending accounting changes warrant a cash flow based valuation approach. GS said it expects company-defined free cash flow to improve from £120m this year to £495m in 2018, £1.02bn in 2019 and £1.55bn in 2020.

Goldman said key risks to its price target and view include a weakening of the pound versus the US dollar through this year which would put downward pressure on sales estimates.

In terms of earnings, the impact would be of a lesser magnitude as a result of the substantial hedge book Rolls-Royce has in place, although large moves in $/£ will still affect the share price.

It also pointed to negative momentum in defence spending in the core markets of the UK and the US, as well as major export markets such as Saudi Arabia, as these markets are driving the growth in newer programs which offsets declines in older products.

Continued declines in sanctioned offshore capex would pressure future revenues in the Marine division from the Offshore exposed business lines.

Standard Chartered Bank

Analysts at JP Morgan downgraded their recommendation on Standard Chartered stock, emphasising that its shares were an "imperfect play" on the US interest rate cycle and how the 'bullish' scenario for the shares required a medium-term perspective.

"Relative to US banks, these banks are imperfect plays on US rates" the investment bank said.

The reason for that was that rate hike cycle in the States needed to be perfectly timed to 'thread-the-needle' between its positive impact on the lender´s net interest margin and the negative impact it might have on asset quality in Emerging Markets, analyst Raul Sinha said in a research note sent to clients.

That was also true of HSBC, whose stock was changing hands at 1.2 times´ P/TNAV.

Furthermore, StanChart shares had already rallied by 80% and HSBC´s by 54% over the past 12 months.

Hence, the risk-reward trade-off looking out over the next year was now less "compelling", Sinha said.

At 0.8 times' price-to-tangible next asset value stock in StanChart was also more geared to delivering improved earnings, as oppossed to the removal of capital concerns, dividends and mergers and acquistions.

Sinha downgraded its recommendation on shares of StanChart from 'overweight' to 'neutral' but stayed at 'neutral' on HSBC.

However, in the case of HSBC JP Morgan raised its target price from 600p to 670p.

"We believe that under CEO Bill Winters, StanChart is pursuing a more sustainable LT recovery strategy, albeit one that will take time to deliver, also less cyclically geared."

Pearson

Education publisher Pearson was under the cosh on Monday as Liberum highlighted concerns about the company’s cash flow.

Pearson, which is due to report full-year 2016 results on Friday, has already stated its headline results and given guidance for 2017, so Liberum said there shouldn’t be any major surprises.

“However, we expect the details of its 2016 results to concern the market particularly around cash flow. We also do not see further major cost savings as a risk to our sell case.”

Liberum noted that at the full-year 2015 results presentation, Pearson emphasised that its underlying cash conversion rate for 2015 was 95% as opposed to the reported 60% as there had been a number of ‘one-off’ issues at the group.

“The implication was that 2016 should see an improvement in the reported rate. However, when it reports numbers, we expect the cash flow numbers to look weak and to raise further questions about their cash flow profile.”

Liberum also pointed to goodwill and said it expects to see more significant writedowns. It said given that goodwill is a reflection of future expectations of cash flow, this would suggest a more negative long-term picture.

The brokerage said there are two areas where there could be risk to its bearish call into the FY numbers: Pearson could announce a new cost-saving programme and/or disposals, particularly around its 47% stake in Penguin Random House.

Liberum reiterated its 'sell' rating and 360p price target on the stock.

Royal Bank of Scotland

If Royal Bank of Scotland retains the Williams & Glyn business, as proposed, it will bring a return to dividends closer and lift earnings in 2019, according to analysts at Morgan Stanley, JP Morgan Cazenove and others on Monday.

RBS confirmed on Monday the statement it released late on Friday, that as it could not sell its Williams & Glyn business it will instead set up a fund to help challenger banks at an estimated cost of £750m that will be taken in this coming Friday's 2016 results.

The plan has been proposed by the Treasury to the European Commission in order to allow RBS to satisfy the remaining State Aid obligations from its 2008 state bailout.

Morgan Stanley said retaining the 300 W&G branches could add around 10% to earnings per share by 2019.

"If the new set of measures is adopted then RBS has a path to clearing one of three remaining hurdles to eventual return of capital," analysts said, with the settlement of US residential mortgage-backed security (RMBS) and a clean stress test being the other two that still remain.

JP Morgan Cazenove said the new proposal as helpful for RBS but potentially disappointing for banks which might have benefitted from a forced sale of W&G, such as CYBG.

Cazenove's upgraded its 2019 estimated EPS by 12% but forecasts a 100 basis-point hit to the bank's tier-one capital levels.

Together this results in the price target being lifted to 210p from 185p, which still results in 13% downside from current levels.

Analysts at UBS saw the proposal as a positive for RBS as it could bring forward its ability to pay dividends.