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Rolls-Royce - Finding the next gear

George Salmon | 2 August 2018 | A A A
Rolls-Royce - Finding the next gear

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 124.66 | Buy: 124.74 | Change -0.22 (-0.18%)
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While Rolls-Royce has reported a £775m operating loss, this is due to one-off events and accounting for currency movements. The adjusted profit figure is £141m, much improved on the £84m underlying loss of last year and ahead of Rolls' previous expectations.

Core 2018 underlying operating profit is expected to be around £350m - £550m, with underlying free cash flows of £300m - £500m. Rolls is confident each will be in the upper half of the range.

The shares rose 3.3% on the news.

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Our view

We like Warren East's strategy to simplify and streamline Rolls-Royce.

We also think that by focusing on cash flow rather than accounting profit, he's using the right metrics to measure success. In recent years you could have flown a plane between Rolls' cash flows and profits, such has been the difference.

The commercial marine and fuel injection businesses have been sold, and what's left behind is a Rolls-Royce focused around three core areas.

The largest of these, Civil Aerospace, has potential. Long-haul business and leisure travel should rise in the future, and Rolls is well-placed to become the leading supplier of the engines those jumbo planes need.

Recent developments are encouraging. Aftermarket revenues are growing again and the next generation of engines are coming through.

Defence and Power Systems are also delivering improvements, while progress is being made with a wide-ranging cost cutting programme that should lop £400m off the cost base within the next couple of years.

The net effect is Rolls is confident it can grow free cash flow to beyond £1bn in 2020. If these projections turn into reality, a few dividend increases would surely follow.

However, there's work to be done yet. Civil Aero remains loss-making, and the costs of resolving issues around the Trent engine line will be in the hundreds of millions for the next few years. That will make hitting those free cash flow targets all the more challenging.

With that in mind, we can't say the engine is roaring just yet. But it does look like Warren East has at last got things ticking over.

The prospective yield is a fairly grounded 1.4% this year. But improvements across the board will give shareholders some optimism Rolls can make good on its plans to increase distributions in the future.

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First half trading details

Underlying half year revenue rose 16% to £6.7bn, driven by improvements in the Civil Aerospace, up 26% to £3.6bn and Power Systems, up 13% to £1.5bn. Revenue in the Defence business was flat at £1.4bn, while the new ITP Aero division brought in £375m in sales. Corporate and intercompany deductions totalled £181m.

Civil Aerospace saw widebody deliveries rise 24%, with 259 engines sold. While the group still reported an operating loss of £112m, this was an improvement on the £261m a year before. Cash flows improved as a result of higher aftermarket activity. ITP Aero profits were £40m.

The group has taken a £554m hit to the income statement from previously identified issues with the Trent 1000 engine range. Total costs are expected to come in around £1.4bn, which will be accounted for over time. Cash costs are expected to step down materially after 2020.

In Defence, underling profit fell 3% to £162m, as a result of a higher R&D spend. Rolls says it has a strong pipeline opportunities in Combat, Naval and Submarines.

Power Systems benefited from higher order intake in a stronger market, while higher margins helped lift profits from £26m to £80m. The integration of the Civil Nuclear operations completed, and L'Orange, fuel injector business was sold to Woodward for total proceeds of EUR673m.

Group free cash flow has improved, but is still negative. Last year's outflow of £339m has been stemmed to £72m, or an inflow of £10m if one only looks at the core businesses.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.