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Less debt, more lift at Rolls-Royce

The iconic UK engineering business once again looks as if it has wings, says Michael Fahy
Less debt, more lift at Rolls-Royce

Investors are often told that a vital factor behind investing is whether a company has a wide enough economic moat – that special something that provides barriers to entry from competitors

Tip style
Speculative
Risk rating
High
Timescale
Long Term
Bull points
  • Recovery of long-haul travel
  • Offloading non-core assets
  • Winning US defence contracts
Bear points
  • Still carrying too much debt
  • Debt-servicing capacity weak

Rolls-Royce (RR.), the manufacturer of heavy-duty engines used in everything from aeroplanes to nuclear reactors, may have one, but seems to have spent the past few years floundering in it as it slipped further and further under water.

The engineering giant wasn’t in the greatest shape heading into the pandemic, after two years of heavy losses when it provisioned for everything from the ending of the Airbus A380 programme (for which it provided engines) to restructuring costs, changing accounting standards and durability problems with its Trent 1000 aero engines.

Then Covid-19 dealt the business a near-fatal blow. Before the pandemic, the company made more than half (53 per cent) of its revenue from its civil aerospace business, selling its engines at a loss upfront and recouping profits on aftermarket services linked to the number of hours engines were flown. Last year, engine sales fell from 510 to just 200 and large engine flying hours were only 43 per cent of 2019 levels. The group reported a loss of £2.9bn and, more worryingly, a free cash outflow of £4.2bn.

Management embarked on a second restructuring within three years, which involved shedding almost one-fifth of staff – 9,000 out of 52,000 roles – in a bid to address “medium-term structural challenges” and to reduce overheads by £1.3bn a year. Rolls also raised £5bn to shore up its balance sheet – £2bn through a rights issue, £2bn via new bonds and £1bn from UK Export Finance.

The timing of that capital raising was unfortunate. The £2bn, tri-currency bond issue took place in October, just weeks before major vaccine breakthroughs were announced, which lifted investors’ optimism. Weighting the issuance, Rolls-Royce is paying a rate of about 5.4 per cent on four- and five-year notes and finished the year with total debts of almost £8.3bn.

Although this figure is set to increase to nearly £10.3bn at the end of this year, thanks to further cash outflows and the drawdown of £2bn from UK Export Finance, things have picked up enough over the past month for City analysts to sharply upgrade earnings forecasts.

 

Flying higher

Consensus forecasts for Rolls-Royce’s earnings per share over the next 12 months have risen to 4.4p as of mid-October, compared with 2.9p a month ago. So what has changed?

First, the UK-US air travel route reopened, which has boosted the prospects for long-haul travel. The International Air Transport Association remains cautiously optimistic about the sector’s recovery, with director-general Willie Walsh saying this month that the industry is “well past the deepest point of the crisis”. Revenue passenger kilometres, a measure of how much paying passengers are travelling, is forecast to remain at 40 per cent of pre-Covid levels this year, but to increase to 61 per cent next year, according to the association’s latest forecast. The long-haul routes on which most of Rolls-Royce’s engines fly will be slower to recover, though – at 44 per cent of pre-Covid levels next year.

Another bright spot for the company is the sale of its ITP Aero business in Spain, which is expected to complete in the first half of next year. The €1.7bn (£1.44bn) disposal to private equity house Bain Capital means Rolls-Royce has already exceeded a target set late last year to realise £2bn by offloading non-core businesses. It has already sold a 23 per cent stake in the Air Tanker refuelling company for £189m last month and the Bergen Engines business for €63m in August. A civil nuclear instrumentation and control business is expected to be sold by the end of this year.

These will help to stem Rolls-Royce’s haemorrhaging of cash, with a further £1.17bn outflow experienced in the first six months of 2021. Management says it expects the group to start generating cash in the second half as it delivers £1bn of its pledged savings, having removed 8,000 of the 9,000 roles targeted for redundancy.

The third significant piece of good news was its defence arm securing a 30-year contract from the US Air Force to replace engines for its B52 planes. The $2.6bn deal involves the supply of 608 F130 engines, as well as spares and associated support.

“That award isn’t material to numbers, but it supports the outlook for the defence business and handily reminds everyone that there’s more to Rolls-Royce that civil aero,” says Rory Smith, an analyst at broker Investec.

 

Building back debtors’ confidence

As Rolls-Royce’s balance sheet deteriorated last year, its debt was downgraded to junk status, so another management goal is to restore its investment-grade rating. Developments in recent weeks are “credit positive”, ratings agency Moody’s Investors Service said earlier this month, although it maintains its sub-investment grade Ba3 rating and its negative outlook on the group.

The B52 contract win was “a positive and somewhat unexpected development” given strong competition from US-headquartered incumbent Pratt & Whitney and GE, the ratings agency said. It added that, if Rolls-Royce continues to provide evidence it is meeting turnaround targets and returns to a sustainable cash breakeven position, this “would support strengthening of the rating and the outlook”.

This is far from certain though, and the company remains highly levered. Moody’s estimates its total debt by the year-end will be 9.7 times earnings. Its ability to service debt in the short term remains weak, with earnings for this year only covering 60 per cent of its interest charge.

So buying into the Rolls-Royce recovery story is undoubtedly speculative, with both its cash flows and book value likely to be negative this year and the terms of its loan agreement with UK Export Finance forbidding any dividend payments until at least 2023.

On top of this, much of the good news surrounding the group in recent weeks may well be priced in. Its share price is up 27 per cent in the past month, giving the company a market capitalisation of £12bn. The current price of 145p is above the average of brokers’ price targets of 126p, according to data provider FactSet.

 

The nuclear option

Arguably, however, the rerating could go further. The group’s defence business, which provided 29 per cent of 2020’s revenue, continues to perform well in a strong market and its power systems business could benefit from the current energy crisis, which is forcing the UK government to take another look at its long-term capacity. The UK’s large-scale nuclear reactor programme has become bogged down while it works out what to do about Chinese involvement, making a proposal to build 16 small modular reactors by a consortium led by Rolls-Royce more appealing.

Press reports ahead of next week’s government spending review suggest Rolls-Royce’s group, which includes the National Nuclear Laboratory and builder Laing O’Rourke, will receive match-funding from the government that will kick-start the programme.

Like the B52 engines win, the sums involved may not bring a huge boost to short-term profits, but they would provide further validation of the group’s engineering credentials and demonstrate that it is not as bad a business as the past few years suggest. And if the aviation arm continues to recover, Rolls-Royce's lower cost base will allow it to generate much-needed cash to bring down debt further and create more value for shareholders. Worth the gamble.

 

Company DetailsNameMkt CapPrice52-Wk Hi/Lo
Rolls-Royce (RR.)£12.1bn145p148p / 64.9p
Size/DebtNAV per share*Net Cash / Debt(-)Net Debt / EbitdaOp Cash/ Ebitda
Net Liab-£5.00bnna-
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)CAPE
33--1.8%-
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
-2.0%--2.9%-
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
na71%58.6%7474.1%
Year End 31 DecSales (£bn)Profit before tax (£m)EPS (p)DPS (p)
201814.30.515.94.04
201915.30.575.54.04
202011.8-3.66-66.80.00
f'cst 202111.80.250.80.00
f'cst 202212.80.705.40.00
chg (%)+8+180+575-
source: FactSet, adjusted PTP and EPS figures  
NTM = Next Twelve Months   
STM = Second Twelve Months (i.e. one year from now)