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Rolls Royce - Tough conditions but full year guidance unchanged

Half year underlying revenue improved 4% to £5.3bn, on an organic basis. That reflected a recovering market in Power Systems, and progress...

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Half year underlying revenue improved 4% to £5.3bn, on an organic basis. That reflected a recovering market in Power Systems, and progress in Civil Aerospace. Increased spending in Defence, Power Systems and New Markets contributed to underlying operating profit falling to £125m, less than half the previous year's level.

The group's experiencing the difficulties of supply chain issues, cost inflation and the war in Ukraine, and these are expected to continue into 2023. For the current financial year, guidance is unchanged, including expectations of low-to-mid-single digit underlying revenue growth, and underlying operating margins of 3.8%.

The shares fell 4.7% following the announcement.

View the latest Rolls-Royce share price and how to deal

Our view

Rolls Royce will be one of the last to fully recover from the effects of Covid. It produces aeroplane engines for larger, long haul planes. A huge amount of its revenue comes from servicing those engines, with business based on how many hours those engines spend in the air.

It's going to be another couple of years until so-called engine flying hours are back to pre-pandemic levels. And until that happens there's a ceiling to how high Rolls Royce can fly. For all the challenges, the group is doing reasonably well within the elements of the situation it can control.

It's undertaking a huge restructuring effort which is lightening the load of recent scars. Three of four disposals have competed, with the final business to get the boot imminently. This was a necessary move, with the proceeds, said to total around £2.0bn, to be put toward restoring the balance sheet by paying down debt which shot up during the pandemic.

We view this turning point as a good time for a handover for newly minted CEO, Tufan Erginbilgic to take a fresh look at things.

The leaner organisation has shown signs of strength. Two years ago, the group saw £4bn of cash walk out the door, last year that fell to £1.5bn and at the half year mark it's in touching distance of break even. Barring any significant disruptions, the group is on track to be free cash flow positive this year. This should help debt make its way lower and would go a long way in restoring our faith in Rolls' ability to stand on its own two feet.

Rolls' multi-billion pound order book gives the group a good deal of visibility over future revenue as well. And it's backed by reliable defence contracts. This is a small but mighty part of Rolls' portfolio. It's a diamond in the rough, and being that it supports defence departments around the world, some level of income for the company is basically guaranteed, particularly in the current climate.

Rolls' position in the defence and aerospace industry is enviable - high barriers to entry means there are very few smaller competitors sniffing around. However, valuing that long term opportunity is a challenge at the moment. Huge asset write-downs mean traditional valuation metrics - like Price/Book or Price/Earnings - don't tell the full story for Rolls-Royce stock. For that reason, we've used Rolls' Price/Sales ratio in the box below to offer a valuation touch point as it indicates how much the market is willing to pay for each pound of expected sales. But it's not a perfect indicator since it doesn't account for debt or profitability - both of which are troublesome for Rolls right now.

Rolls is also barred from paying dividends until at least 2023 as part of its loan terms. Even without that red tape, the group couldn't pay a dividend because it's sporting a negative equity position - meaning liabilities outweigh assets.

It appears the worst might be over for Rolls, and we're more positive than we have been, but there's still work to be done. While aviation's made a comeback, it'll be the first to feel the sting of a prolonged economic downturn. With no dividend on offer to make the wait more palatable, shareholders should be prepared to stomach some turbulence.

Rolls-Royce key facts

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

Half Year Results (figures are reported on an organic and underlying basis)

In Civil Aerospace, revenue rose 8% to £2.3bn, which was partially offset by the mix of engine deliveries - including fewer large spare engines sold. Service revenue rose 16% to £1.7bn. Large engine flying hours (EFH) were up 43%, against a weak comparison last year, and this was equal to about 60% of pre-pandemic levels. EFH levels are expected to return to 2019 levels in 2024. Operating losses narrowed to -£79m from -£124m.

The timing of contracts and a 12% drop in Services revenue contributed to a 9% fall in Defence revenue to £1.6bn. The overall order intake was £1.4bn and the order book now stands at £6.5bn. Lower revenue and increased spending meant operating profit fell 32% to £189m.

Demand for Power Systems products remains "very strong", and the division enjoyed a record order intake of £2.1bn. Revenue was up 20% to £1.4bn, while operating profit increased £80m to £119m. Despite this, growth is being held back by supply chain issues, which are limiting the availability of some core components.

Free cash flow improved to a £68m outflow, compared to an outflow of £1.2bn last year. That partly reflects the effect of increased EFH. Net debt stood at £5.1bn at the end of the period - the group acknowledged there were no "significant" debt maturities until 2024.

Rolls Royce has received regulatory approval for the sale of ITP Aero, and the deal is expected to complete in the coming weeks. Proceeds will be used to repay a loan which has exposure to interest rate increases.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. 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 disclosure for more information.

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Written by
Sophie Lund-Yates
Sophie Lund-Yates
Lead Equity Analyst

Sophie is a lead on our Equity Research team, providing research and regular articles on a selection of individual companies and wider sectors. Sophie's specialities are Retail, Fast Moving Consumer Goods (FMCG), Aerospace & Defence as well as a few of the big tech names including Facebook and Apple.

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Article history
Published: 4th August 2022