By Sarah Young
LONDON (Reuters) - Rolls-Royce
The company's shares climbed 7.4 percent to 1,085 pence, their highest in more than two months, after it made the announcement on Thursday. The stock had lost 17 percent of its value over the past six months.
Investors' confidence in Rolls-Royce has been shaken by an acquisition attempt followed by a profits warning earlier this year and an engine order cancellation last month.
"The buyback is good news because it shows the company is committing itself to very tight capital discipline, prioritising rewarding shareholders ahead of expanding the footprint. This is exactly the message we were looking for after a challenging six months," said Espirito Santo analyst Edward Stacey.
Rolls-Royce upset investors in January when it revealed it had made an 8 billion euro takeover approach to Finnish ship and power plant engine maker Wartsila
Although unsuccessful, the move left some investors wondering whether the company was spending indiscriminately in the pursuit of growth.
Rolls-Royce was interested in Wartsila as a way to strengthen its Marine engine business, where it has cut profit forecasts twice in a year.
The share buyback "shows they get how much the Wartsila story frightened investors", said Edison analyst Sash Tusa.
Shares in Wartsila, which analysts had thought could still be in Rolls-Royce's sights, fell 5 percent.
Speaking to investors on Thursday, Rolls-Royce Chief Executive John Rishton conceded that the company needed to communicate better with them.
Starting in October, Rolls-Royce plans to switch to issuing its outlooks in percentage and number terms, instead of its historic references to "good" or "modest" growth, he said.
Rolls-Royce also said it would reduce group capital expenditure to 4 percent of underlying revenue over the next three to five years from 4.9 percent at the end of 2013.
The 1 billion pound payout to shareholders will take the form of a share buyback, the company's first since it was privatised in 1987.
It is equivalent to about 5 percent of Rolls-Royce's 19-billion-pound market capitalisation, and will be funded partly by proceeds from the 785 million pound disposal of its industrial gas turbine unit to German conglomerate Siemens AG
Rolls-Royce reiterated that it was on track for flat earnings this year and to return to growth in 2015, when it is due to ramp up aero engine production.
Until February, the company had enjoyed 11-years of strong profit and revenue growth as soaring demand for more fuel-efficient engines for passenger planes made by Airbus
"I'm confident that we have sustainable growth, but that does not mean year-after-year consistent growth, it means long term sustainable growth," Rishton said.
Analysts expect Rolls-Royce to post flat pretax profit of 1.7 billion pounds for 2014. Before February's warning, they had expected growth of 8 percent.
(The story corrects paragraph 14 to show Rolls Royce sold its industrial gas turbine unit to Siemens, not its overall gas turbine unit.)
(Editing by Erica Billingham)