Disembark from stalling Rolls-Royce

Supplying wide-body engines to Airbus (FRA:AIR) and Boeing (US:BA) – both of which have seen orders cancelled or deferred – Rolls makes an average loss per unit. But it makes up for this by collecting revenue over an engine’s lifetime according to how many hours it flies. Engines flying hours dipped 25 per cent in the first quarter of 2020, plummeting 50 per cent year on year in March alone. Further deterioration is expected. Broker Jefferies estimates almost two-thirds of the world’s aircraft fleet is currently grounded.

Rolls’ ‘risk and revenue sharing partners’ (RRSPs) are suppliers who help finance engine development and receive a proportion of revenue generated. According to JPMorgan Cazenove, RRSPs have larger stakes in newer engines. So, with older grounded aircraft heading for early retirement, a higher percentage of cash flows will be paid out in future. Early retirements will also hit higher-margin aftermarket sales, with Jefferies expecting a 25-50 per cent decline this year.

Before coronavirus arrived, Rolls was addressing blade deterioration issues with its Trent 1000 engines. A £1.4bn exceptional charge last year reflected compensation costs and provisions against future losses. Together with restructuring costs, ‘one-off’ Trent charges have pushed Rolls into a statutory loss for the past two years. Cash costs for Trent 1000 in-service issues amounted to £578m in 2019, with a total £2.4bn anticipated between 2017 and 2023.

Having aspired to reach £1bn of free cash flow in 2020, this target has been canned alongside the rest of its guidance and final 7.1p dividend. While it declared £873m of free cash flow last year, this was flattered by advance payments from customers for future aftersales work – so-called ‘long-term service agreement payments’ (LTSA). Rolls books the net change in its LTSA balance in its cash flows, which added £754m in 2019. Really, this is deferred revenue and only the profit when these services are actually undertaken is cash belonging to the company. Besides, LTSA payments are likely to drop as the active engine fleet shrinks.

Including £2.35bn in lease liabilities, the £993m of net debt reported for 2019 (and earlier years) is arguably understated, given that supply chain financing (SCF) – paying suppliers early via short-term bank loans – is recorded as working capital rather than debt. Rolls used £859m of SCF last year, up from £817m in 2018.

Rolls believes it has sufficient liquidity for the ’Corona crunch’. It added a £1.5bn revolving credit facility, and having fully drawn a £2.5bn facility, had gross cash of £5.2bn as at 31 March. But it used £1.7bn of cash in the first three months of this year, which it attributes to seasonal working capital movements and a £300m coronavirus headwind. JPMorgan thinks Rolls is “severely under-capitalised” and will need to raise £6bn of equity. Meanwhile, a £208m pension deficit (from a £641m surplus in 2018) could widen, as market turmoil sees scheme asset values tumble and lower interest rates push up liabilities.

Providing just over half its total £808m of underlying operating profit in 2019 and a fifth of revenue, Rolls’ defence activities should remain stable, benefiting from long-term government contracts and exposure to rising US defence spending. With a record £5.3bn order intake last year, this includes a five-year $1.2bn (£1bn) contract to maintain AE1107 engines for the US military.