Rolls-Royce stymied by further aviation disruption

Years of disappointment for Rolls-Royce (RR.) investors looked as if they may have been coming to an end in the back half of last year. The company, which has lost money for five of the past six years, had made progress with its restructuring, slashing overheads and kicking off the first round of asset disposals aimed at bringing in £2bn to shore up its balance sheet. Its consortium that plans to build small modular nuclear reactors also made decent headway, raising millions from the UK government and partners.

Yet just as the iconic maker of jet engines seems poised to build momentum, external matters conspired to delay the anticipated revival of air travel - a major setback for Rolls-Royce as a major chunk of its revenue is tied to how many hours its engines stay in the air. First it was the emergence of Omicron. Then, on the day it announced a net profit (after a £418mn tax gain) of £124mn, compared to a prior-year loss of £3.1bn, Russia’s invasion of Ukraine threw aviation-related shares into a tailspin.

The announcement that its longstanding chief executive Warren East, who has been in the top job for eight years, is to leave also didn’t help. The company’s shares slumped by 18 per cent in early trading before paring losses. Over the past two years, they have lost more than 50 per cent of their value, compared to a 4.8 per cent gain for the FTSE 100.

Its current market capitalisation represents just eight months of consensus forecast sales of about £12.6bn.

This is understandable. Although it cut more than 9,000 jobs, which will lead to annual savings of £1.3bn a year, there was still a cash outflow of £1.5bn last year, meaning net debt climbed to £5.2bn.

This should come down once the €1.7bn (£1.42bn) sale of the ITP Aero business to Bain Capital is finalised. The haemorrhaging of cash should also end, with the company forecasting positive cash flow this year, albeit weighted towards the second half.

East told investors on an earnings call that Rolls-Royce is now a better balanced business. The size of its civil aerospace arm has been cut by a third and should benefit from operational gearing as revenues return, while its defence and power systems arms now play a much bigger role – contributing almost 60 per cent of last year’s sales.

The company’s shares are trading over 20 per cent below the level they were at when we flagged them as a buy in October, but Rolls-Royce is in much better shape and once air travel volumes make a sustained recovery we think the shares will quickly rebate. Buy.

Last IC View: Buy, 127p, 04 Jan 2022