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Rolls-Royce - lots of exceptionals, but underlying progress

George Salmon | 28 February 2019 | A A A
Rolls-Royce - lots of exceptionals, but underlying progress

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 82.83 | Buy: 82.93 | Change 0.35 (0.42%)
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Rolls-Royce has reported an operating loss of £1.2bn, but after adjustments including one-off charges of £976m against the Trent 900 and 1000 engine programmes, the group says underlying profits rose 71% to £633m.

Rolls-Royce also confirmed it is to withdraw from the bidding for Boeing's new midsize plane.

The shares fell 3.5% 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.

While Rolls deserves credit for improving its working capital position by negotiating better terms with suppliers, the group is still benefitting from high upfront payments for servicing work, and £70m of restructuring costs were excluded from this year's free cash flow.

All the while, Civil Aero remains loss-making and the costs of resolving issues around the Trent engine line will keep racking up. With that in mind, we can't say the engine's 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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Full year results

Total group revenue was £15.7bn, of which £14.3bn is classed as ongoing core revenue, following the disposal of L'Orange and Commercial Marine classed as discontinued. Once the impact of exchange rate movements and portfolio changes are excluded, that represents growth of 10%.

Growth was strongest in the Power Systems business, where extra volumes in end markets from commodities to data centres pushed revenue up 15% to £3.5bn. Operating profit rose 20% to £317m.

Civil Aerospace saw revenues rise 12% to £7.4bn, with operating losses halving to £162m, on account of lower losses on new engines, extra spare sales and strong servicing revenues.

Defence revenue was flat at £3.1bn as higher original equipment sales, boosted by transport engines and a contract on the UK's Dreadnaught submarine offset lower servicing sales. Higher R&D expenses saw profits fall 4% to £427m.

The ITP Aero business, acquired in December 2017, saw comparable revenue rise 6% to £779m, with operating profit up 3% to £67m, with margins impacted by a share of the Trent 1000 issues and lower volumes of EJ200 engines.

Free cash flow in the year improved from £309m to £568m, driven by higher profitability, good cash collections and a change in supplier terms. These factors more than offset an extra R&D spend and an extra £119m of Trent 1000 in-service outflows. Rolls-Royce reiterated its goal of at least £1bn free cash flow by 2020.

Cost saving measures were introduced during the year, including a 1,300 net headcount reduction. The group expects to achieve£400m of annual savings by the end of 2020.

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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.


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