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Rolls-Royce - 2021 cash flow under pressure

Sophie Lund-Yates, Equity Analyst | 26 January 2021 | A A A
Rolls-Royce - 2021 cash flow under pressure

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Rolls Royce Holdings Plc Ordinary 20p

Sell: 142.12 | Buy: 142.20 | Change -4.82 (-3.27%)
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Enhanced restrictions are delaying the recovery of long-haul air travel. As a result, Rolls Royce is now forecasting a £2bn free cash outflow in the 2021 financial year. The worst of this will be in the first half - the group continues to think it will turn cash flow positive in the second half.

Widebody engine flying hours are expected to be around 55% of 2019 levels next year, which is lower than the previous guidance of 70%. Rolls acknowledged significant uncertainty remains, and these predictions could change.

The group highlighted that full year 2020 free cash outflow was in line with previous guidance. Year-end liquidity was around £9bn, at the higher end of guidance. The restructuring efforts saw 7,000 jobs removed this year - this should rise to 9,000 by 2022.

The shares fell 5.6% following the announcement.

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Our view

Rolls Royce produces and services aircraft engines, increasingly for bigger widebody planes (think planes with two aisles). The latest update confirms that the delayed recovery in long-haul travel will weigh on 2021 cash flow.

A big part of that is because Engine Flying Hours (airlines pay for engine services depending on how many hours their Rolls Royce engines spend in the air), are expected to recover more slowly than planned. Servicing is usually a big part of revenues. So, this news and adds further justification for the group's dilutive £2bn emergency rights issues earlier this year.

And not only are customers not having their existing engines serviced, few are ordering new ones. Coupled with very large, very fixed costs, and the net effect is a serious cash outflow problem. Around £4.2bn is expected to walk out the door this year.

Enter the biggest restructuring effort Rolls has ever undertaken. 9,000 people will lose their jobs by 2022, disposals are underway, and investment is being funnelled away from Civil Aerospace - previously the core division.

There are clearly difficult issues to deal with. The proceeds from the rights issue, plus the extra loans the group now has access to adds some much needed support to the balance sheet. The group expects to finish the year with $9bn worth of liquidity, so we don't have immediate concerns on this front. But while conditions remain volatile, this is what we'll be watching. Even the biggest resource pile can be depleted if torrid conditions last long enough.

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. 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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Trading details (11 December 2020)

Rolls Royce expects a free cash outflow of around £4.2bn this year, reflecting the impact of the second wave. This could change, depending on the timing of "significant" seasonal payments at the end of the year.

The group still plans to deliver the reduced number of 250 large engines for the full year.

In Civil Aerospace Engine Flying Hours (EFH) have gradually improved since the trough in April, although the pace of progress has slowed recently. In the third quarter EFH was 29% of 2019 levels, compared to the 24% seen in Q2. Business flying activity has held up quite well during the disruption when compared to commercial flights.

UK defence budget increases and new orders from the German Air Force are positive developments for the Defence business. Cash conversion is "good" in this division, and the order book for 2021 is said to be strong.

Covid-19 resulted in a significant fall in demand for Power Systems, especially from non-government customers. Activity declines continued in the second half of the year, although trends in China have turned more positive.

The group's nuclear energy arm has signed strategic agreements with Exelon Generation and CEZ and the UK Government has committed £215m for a four-year development plan for Small Modular Reactors.

The group said: "we have made good progress towards our target for £1.3 billion of pre-tax cash cost savings and a reduction of at least 9,000 roles by the end of 2022". Redundancies are running ahead of schedule. As part of the Civil Aerospace restructuring, Rolls is considering moving its facility and workforce to Hucknall in Nottinghamshire. It may also consolidate the manufacture of aero-engine structures into ITP Aero.

In December the group agreed to sell its civil nuclear instrumentation and control business, in line with plans to raise at least £2bn from disposals.

Rolls expects to end the year with net debt of between £1.5bn - £2.0bn, excluding lease debt of approximately £2.1bn.

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