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Rolls-Royce - new shares issued to market following rights issue

Sophie Lund-Yates, Equity Analyst | 28 October 2020 | A A A
Rolls-Royce - new shares issued to market following rights issue

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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 shares fell 64.0% this morning, following the issue of 6,436,601,676 new ordinary shares. This is a function of, and in line with, the rights issue announced at the beginning of October.

If you hold shares with HL we will contact you with further details shortly.

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Our view

Companies only come cap-in-hand to investors for two reasons. The first is to allow it to capitalise on an opportunity. The second is because funds are needed to protect the business.

In Rolls' case we are sitting squarely in the second scenario.

Coronavirus is the stuff of nightmares for Rolls Royce. Intrinsic ties to long haul aviation make the collapse of international travel a serious problem. Not only are customers not having their existing engines serviced - which is a major part of revenue - few are ordering new ones.

Coupled with very large, very fixed costs, (equipment needed to build and house jet engines doesn't come cheap, and it can't be flexed), and the net effect is a serious cash outflow problem.

The group expects £4bn to walk out the door next year. That could get worse still if conditions deteriorate. It's arguably not the best time to be scrabbling around trying to find a new CFO.

Enter the biggest restructuring effort Rolls has ever undertaken. 9,000 people will lose their jobs, disposals are underway and investment is being funnelled away from Civil Aerospace - previously the core division.

There are clearly huge issues to circumvent. The £2bn proceeds from the rights issue, plus the extra loans available if it's successful, would provide some welcome relief to the group's balance sheet.

The discount being offered on the new shares is also notable. It suggests Rolls feels the need to really convince investors to take up the rights - a bit like a shop window with a "clearance" sign. If investors don't take up their rights they risk being severely diluted.

We should be clear there aren't immediate concerns over liquidity. The extra money is needed for longer-term resilience, rather than keeping the lights on next week.

There is some good news. Rolls 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.

There is an outside chance the Defence business gets sold to the highest bidder, should conditions deem it necessary. This is very much off the table at the moment, but it is a possibility. That would strip Rolls of one of its key assets in our view.

Ultimately, the group is at a cyclical low point - although whether we're at the bottom remains to be seen - and a lack of a clear profit trajectory makes it hard to value at the moment too. Rolls Royce isn't in a terminal nose dive, and the bull case focuses on the fact its specialist products and services means it still has long-term attractions. But we could be looking at a very different business on the other side of all this, and investors need to be prepared for things to get worse before they get better.

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Fundraising and cost saving details

Rolls Royce has announced plans to raise £2bn from a 10-for-3 rights issue - existing shareholders will be able to buy 10 new shares for every 3 they own, at 32p each.

The group also launched a bond offering, raising a further £2bn, and a new £1bn two year loan facility had been agreed if the rights issue goes ahead.

There's been no material change the outlook from half year results at the end of August, although free cash outflows have been slightly better than expected. Rolls continues to target generating positive free cash flow by the second half of 2021. However, this depends on the rate of recovery in long haul travel.

Looking ahead, the group will be prioritising investment in the Defence and Power Systems businesses, where it sees more opportunities.

The rights issue was contingent on shareholder approval and the price represents a 41.4% discount to the theoretical ex-rights price (based on the closing price on 30 September).

The new £1bn loan facility is dependent on the completion of the rights issue and cancellation of the £1.9bn funding agreement, which is currently undrawn. The loan would be due two years after the start of the new facility.

UK Export Finance has also said that, in principle, it would support an extension of its 80% guarantee of Rolls' existing £2bn five year term loan, to support an increase in the loan amount of up to £1bn. However, this increase depends on a successful rights issue, and agreement of the new loan terms with lenders and the Treasury.

The group believes these measures are needed to boost liquidity and increase financial resilience until it returns to free cash flow generation. The timing of this is dependent on the ongoing uncertainty surrounding the economy and demand in its key markets.

The restructuring programme, including reducing headcount by 8,000 in the Civil Aerospace business is ongoing, with 4,800 people having left by the end of August. Rolls is also reducing its central functions, with headcount here reducing by 20-25% by the end of 2021.

Combined with other cost saving measures, this will result in an annual pre-tax cash saving of at least £1.3bn by the end of 2022. The restructuring is expected to result in cash costs of around £800m, phased over the next three years.

Half year results (underlying figures unless otherwise stated) 27 August 2020

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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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.