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Rolls-Royce - considering raising a further 2.5bn

Sophie Lund-Yates, Equity Analyst | 21 September 2020 | A A A
Rolls-Royce - considering raising a further 2.5bn

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 226.80 | Buy: 227.00 | Change 7.00 (3.18%)
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Rolls Royce has confirmed it's considering different types of funding options to strengthen the balance sheet. This could involve raising up to £2.5bn through "a variety of structures", including a rights issue, other types of equity issuance and issuing new debt.

The group said no decisions about when this might happen, or the final amount to be raised, have been made. Rolls reiterated it's identified a number of disposals expected to generate over £2bn in the next 18 months, including the ITP Aero business.

The shares fell 10.3% following the announcement.

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Our view

COVID-19 is the ultimate monster under the bed for Rolls Royce, thanks to the group's intrinsic ties to the battered civil aviation industry. The group produces and services aircraft engines, increasingly for bigger widebody planes (think planes with two aisles).

Rolls' servicing model charges a fixed amount on a per-flying-hour basis, so the grounding of plane fleets earlier this year had a big impact on performance. And while things are gradually recovering, flight activity isn't going to normalise for years. That means revenues and profits are in for a turbulent time.

There's also the question of production. Rolls' main customers are not only not servicing existing engines, but few are ordering new ones. That means the group won't be delivering as many engines as planned, which reduces revenues and profits this year and also affects future servicing revenues.

The extent of the damage will depend squarely on when airlines feel confident enough to splash the cash on new jet engines. We suspect it will be some time.

Rolls itself is forecasting lower revenue for at least the next seven years, which has sparked major restructuring efforts. If your end market has shrunk, sadly your operations need to fall in line too. And keep in mind, there's always the possibility of a second wave, which would set things back further.

The inevitable knock to profits and cash flow isn't the best news. Cash flow has been a thorn in the group's side before, and £4bn is expected to slip out the exit this year. This is being compounded by Rolls' largely fixed cost base - not the best set up for a sudden drop off in activity. It's arguably not the best time to be scrabbling around trying to find a new CFO.

The group does have substantial liquidity and there are no immediate concerns on that front. However, the sheer scale of the cash flow exodus means it's looking like a case of "when" not "if" for dilutive equity raises, and disposals are squarely on the to-do list too. If they come to fruition, these developments have unsurprisingly irked shareholders, but we believe it's the right thing to do for the long-term health of the business.

For all the short term pain, Rolls Royce still has some real positives.

It can boast a multi-billion pound order book, boosted by reliable defence contracts. That gives the group excellent visibility over a certain amount of revenue. Defence spending should remain robust, and being a go to "critical" defence supplier for the UK and US governments is a great position in our view. Longer-term, Rolls Royce's scale and very high barriers to entry should hold it in good stead.

We expect Rolls to make it through the disruption, and its long-run attractions remain intact. However the group's a classic example of a cyclical company, meaning its fortunes wax and wane with the economy. Investors need to strap in for more turbulence ahead, and the business we'll be looking at on the other side will be a bit of a different, slimmer beast.

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Half year results (underlying figures unless otherwise stated)

Underlying revenue of £5.6bn was £1.6bn lower than last year, ignoring the impact of exchange rates. That reflects coronavirus disruption and a significant reduction in new engine deliveries.

The group posted a pre-tax loss of £3.2bn, largely driven by the disruption in Civil Aerospace and one off charges relating to the forecast reduction in flying hours. The group also decided to reduce its hedging activity, which is an important part of its financing structure, and this led to a further charge of £1.5bn. On a reported basis, there were a further £1.5bn in non-cash charges, as the crisis meant the value of some assets were reduced or written off.

Ongoing uncertainty for civil aviation means Rolls is considering selling the ITP Aero business, among other assets, and is "continuing to assess additional options to strengthen" the balance sheet.

Civil Aerospace delivered 137 widebody engines, compared to 257 this time last year - 250 are still expected to be delivered for the full year. Flying hours from long-term service agreements fell 47%, although these have started to slowly recover from the lows in April. Maintenance activity was slightly higher year-on-year because of backlogs from lockdown, but this will reduce next half. EFH are expected to recover to 70% of normal levels by 2021.

Overall revenue of £2.5bn was 37% lower than 2019. Paired with higher research and development spending, the operating loss was £1.8bn, compared to £21m last year.

The previously announced restructuring programme is underway, with a reduction in headcount of 4,000 so far, and 8,000 members of staff are expected to leave the division overall. Rolls Royce expects annualised pre-tax savings of at least £1.3bn across the Group by the end of 2022.

Power Systems posted revenue of £1.3bn, an 11% reduction on 2019 and reflects weaker demand in industrial markets for some products. Operating profit was down 79% to £22m, which includes the lower revenues as well as the negative effect of reduced factory usage - which hurt margins. Demand during the second half is expected to remain weak for industrial end markets, particularly for oil and gas, while governmental business looks more robust

Defence was more resilient, with revenue rising 2% to £1.6bn - the group said there's been no material impact from COVID-19. The division saw an order intake of £1.2bn, which was in line with expectations. Operating profit rose ahead of revenues, thanks to a favourable mix of products, rising 19% to £210m.

The ITP Aero business was affected by lower engine volumes on civil programmes, which fed into a revenue decline of 24% to £346m. Operating profits were £10m, compared to £32m last year.

The reduction in engine flying hour receipts as well as the decision to stop invoice discounting (a form of short term borrowing, where unpaid invoices are sold), meant there was a free cash outflow of £2.8bn, compared to £429m. The cash outflow for 2020 is still expected to be around £4bn. Net debt increased substantially to £4.1bn, from £993m at the start of the year.

To strengthen the balance sheet, Rolls has identified potential disposals which would generate over £2bn. The group had total liquidity of £6.1bn at the end of June, including £4.2bn in cash and £1.9bn in undrawn credit. A further £2bn loan was finalised this month.

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