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Rolls-Royce cuts cash outflows but profit slumps

The engine maker expects "modestly positive" cash flow by the year end
August 4, 2022
  • Reduction in the underlying operating margin
  • Engine flying hours on the rise 

Rolls-Royce’s (RR) return to profitable growth is taking longer to deliver than expected, with the slow recovery in the market for long-haul travel dampening the recovery of its civil aerospace arm.

A big reduction in the company’s underlying operating margin – to 2.4 per cent, from 5.9 per cent a year earlier – meant a 60 per cent drop in its underlying profit to £125mn, which was below analysts’ expectations.

The engine maker made good progress with its attempt to stem the haemorrhaging of cash from the business experienced in recent years, though. Cash outflow in the first six months of the year was £68mn, down from almost £1.2bn in the first half of last year and £2.9bn two years ago. It expects to generate “modestly positive” free cash flow over the full year.

Around £500mn of the £1.1bn cash flow improvement came from the fact that its civil aerospace arm was more active. Although it declared an operating loss of £79mn, the division generated a trading cash flow of £63mn, compared with an outflow of almost £1.1bn a year earlier. 

The number of engine flying hours recorded under long-term service agreements increased by 33 per cent year on year, with hours flown by large engines growing by 43 per cent. 

This is still only around 60 per cent of 2019 levels but the current trajectory means outgoing chief executive Warren East remains “reasonably comfortable” with its existing guidance of 60-70 per cent for the full year and for a full recovery to pre-pandemic levels by 2024.

Operating profit in its defence arm fell by a third on a 9 per cent decline in revenue, with chief financial officer Panos Kakoullis arguing that it’s a “long-cycle business” that doesn’t immediately benefit from the changing geopolitical picture. The division’s order book grew by £1.4bn to £6.5bn, though, and Kakoullis said it’s bidding for other work, including providing engines for new long-range Dassault aircraft the US Army will use to replace its fleet of Black Hawk helicopters.

Higher spending by western governments should allow it to secure more work on long-term defence programmes, though, bringing in “annuity-like cash flows”, he added.

Its power systems arm was the standout performer in the first half, with revenue up 20 per cent and operating profit trebling to £119mn on much higher margins, although it consumed more cash as it built inventory to overcome supply chain problems. 

Despite Rolls-Royce increasing its overall inventory spend by over £470mn to navigate supply chain challenges, it spent £400mn less on working capital because of an £800mn swing in contract balances between payables and receivables, with the defence businesses receiving advanced payments and deposits for engines. Cash payments on pensions and hedging costs were also around £200mn lower year on year. 

Berenberg analysts said the improvement in Rolls-Royce’s cash flow was “the key standout” from the results, and ahead of expectations. Approval by the Spanish government earlier this week of the company’s £1.3bn deal agreed last September to sell its ITP Aero division to Bain Capital should also help it to pay down borrowings – net debt for the six-month period ended flat at £5.1bn.

Like many firms connected to the aerospace sector, Rolls-Royce’s shares have faced headwinds and are down by a third since the start of the year. They trade at 20 times UBS’s forecast earnings for this year, falling to 11 times by 2024 when engine flying hours are due for a full recovery.

On a longer-term basis, the improved outlook for Rolls-Royce's defence business and the progress made by its consortium to develop small modular nuclear reactors means there’s still plenty of growth potential as its balance sheet improves. Buy.

Last IC View: Buy, 104p, 4 Feb 2022

ROLLS-ROYCE (RR.)   
ORD PRICE:82pMARKET VALUE:£6.9bn
TOUCH:81.9-82p12-MONTH HIGH:150pLOW: 78p
DIVIDEND YIELD:nilPE RATIO:na
NET ASSET VALUE:*NET DEBT:£5.2bn
Half-year to 30 JunTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
20215.160.114.73nil
20225.60-1.75-19.3nil
% change+9---
Ex-div:-   
Payment:-   
*Negative shareholder funds