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Rolls-Royce: Good news for shareholders at last

Underlying profits and cash flows beat the consensus
February 23, 2023
  • Strengthening cash flows
  • Encouraging order intake

It’s too early for Rolls-Royce’s (RR.) new chief executive, Tufan Erginbilgic, to have made a material difference to the group’s financial performance. But he has now launched a strategic review of the business, after having identified seven areas in need of improvement. Above all, he will know that free cash flow generation will be central to recovery plans.

High-end engineering is a capital-intensive affair and there has often been a significant lag between expenditure and the resultant cash flows that the engine maker generates from long-term maintenance contracts. In the past, the group has been criticised over its accounting treatment of these revenues, but the pandemic and the prolonged technical issues with its Trent 1000 engine series laid bare (and exacerbated) the group’s cash flow challenge.

So, shareholders will take encouragement from news that the group recorded free cash flow of £500mn in 2022, a £2bn improvement on the prior year. This was driven primarily by a 35 per cent increase in large engine flying hours – a critical metric. It meant that “major shop visit volumes” were up by about a fifth. Civil aviation accounts for a sizeable proportion of group revenues, and the good news is that airlines have been steadily adding capacity, which is now within 12.5 per cent of where it was in 2019, according to industry body OAG.

Reported trading profits of £837mn were well ahead of consensus and up by 63 per cent year on year, but the comparative transition through to the bottom line suffered due to £1.88bn in net fair value losses on foreign currency contracts.

Defence revenues ticked up slightly, although profits slipped on an organic basis. Order intake in the defence business more than doubled to £5.4bn with a book-to-bill ratio of 1.5 times against 0.7 times in 2021, suggesting order rates are outstripping fulfilment.

A contracting cash conversion rate reflects a higher level of inventories and the pace of revenue growth, but stock levels started to unwind towards the end of the year. The inventory build was partly offset by a net inflow through collections of overdue debts in civil aerospace and advance payment receipts across the other two main business units.

The market reacted positively to news that free cash flow was in positive territory. And we maintain a speculative buy stance as a turnaround could come about more quickly than anticipated if aviation industry capacity continues to expand – the group can throw off a lot of cash when market conditions are favourable. Chief executive Erginbilgic will certainly be prioritising balance sheet efficiencies, so we could also witness further disposals to help reduce borrowings after the divestment of ITP Aero in 2022. Buy.

Last IC view: Buy, 80p, 07 Nov 2022

ROLLS-ROYCE (RR.)   
ORD PRICE:128pMARKET VALUE:£10.7bn
TOUCH:127-128p12-MONTH HIGH:122pLOW: 64p
DIVIDEND YIELD:NILPE RATIO:NA
NET ASSET VALUE:*NET DEBT:£7.58bn
Year to 31 DecTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
201815.7-2.95-44.34.0
201916.6-0.89-23.71.6
202011.5-2.78-51.8nil
202111.2-0.291.48nil
202213.5-1.50-14.2nil
% change+21---
Ex-div:-   
Payment:-   
* Negative shareholder equity NB: EPS and DPS figures for 2018-19 have been adjusted to take account of Oct 2020 rights issue