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Rolls-Royce - profits up, remains on track

George Salmon | 6 August 2019 | A A A
Rolls-Royce - profits up, remains on track

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 81.40 | Buy: 81.48 | Change -2.34 (-2.80%)
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Rolls-Royce's results show underlying group revenue rising 7% to £7.4bn, with progress across all divisions. Underlying group operating profits rose 32% to £203m, but higher tax and interest costs pushed the group into a £24m loss overall.

While group financial guidance remains unchanged, resolving the Trent 1000 compressor issue has is taking longer than originally planned, and in-service costs are set to increase by a total of £100m across the next three years.

The shares fell 2% on the news.

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Our view

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

By focusing on cash flow rather than accounting profit, he's using a sensible and shareholder friendly metric to measure success. In recent years you could have flown a plane between Rolls' cash flows and profits, such has been the difference.

These days the commercial marine and fuel injection businesses have been sold, and what's left behind is a business focused around three core areas.

The largest of these, Civil Aerospace, is currently loss-making and lagging behind international competitors. But there's potential for a recovery. Business and leisure travel should rise in the future, and Rolls is a leading supplier of the engines for long-haul jumbo planes.

Recent developments are encouraging. Losses from original equipment are narrowing, the all-important aftermarket revenues are growing and the next generation of engines are coming through. Defence and Power Systems are also delivering improvements, with order books building.

Add in wide-ranging plans to lop £400m off the cost base within the next couple of years and the net effect is Rolls is confident it can grow free cash flow to beyond £1bn in 2020, and the best part of £2bn by 2023. The prospective yield is a fairly grounded 1.8% this year. But if Rolls can make good on its plans, a few dividend increases would surely follow.

However, history tells us there are no guarantees that will happen.

The group deserves credit for improving its working capital position by negotiating better terms with suppliers. But there's an array of adjustments and reconciliations in 'underlying' numbers and the group is benefiting from high upfront payments for servicing work. So, while progress is being made, it's difficult to model how quickly.

Predicting the future is difficult, especially in such a complex business. There's scope for the aftermarket business to be stifled by a quicker than expected pace of engine retirements, while weaker economic growth, or a trend towards narrow body craft would also hurt. Neither can be ruled out.

Rolls hasn't got a squeaky clean record on the factors more under its control either. The issues around the Trent 1000 linger on and the group missed guidance on aircraft deliveries this year. With that in mind, we can't say the engine's roaring just yet.

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Half year results

Within Civil Aerospace, organic revenue rose 11% to £4bn, with 3% growth in original equipment (OE) and aftermarket servicing rising 18%. The higher revenue, a drop in underlying OE losses from £1.5m to £1.3m per engine and a higher contribution from JVs helped divisional operating losses narrow from £112m to £21m.

In addition to the higher Trent 1000 costs, the group booked a further £59m impairment against the Trent 900 line as A380 production closes.

Increased utilisation of data centres helped underlying Power Systems revenue rise 6% to £1.6bn, with the order book up by £1.7bn despite economic uncertainty. Underlying operating profit rose 20%, as a better sales mix offset increased commercial and R&D costs.

The Defence business saw revenue and underlying operating profit rise 2%, to £1.5bn and £173m respectively. Performance was boosted by kit enabling F-35 vertical take offs, while there were expected headwinds from the end of the support contract for the RB199 engine.

The Spanish ITP Aero business saw revenues rise 23% to £457m, with operating profits falling from £40m to £32m.

Having reported a £611m net cash position this time last year, the group has now got a net debt of £1.9bn, which reflects a £2.2bn impact from amendments to accounting rules and other cash outflows.

Underlying free cash flow was -£391m, compared to an inflow of £10m last year. This excludes £168m of restructuring and penalty costs, with the increase reflecting higher Trent servicing costs, the usual inventory build and the non-recurrence of servicing customer advances received last year.

The group remains confident of delivering at least £1bn of free cash flow this year, with core underlying operating profit of £600m - £800m.

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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.