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Rolls Royce - cost saving drives return to profit

Underlying revenue declined 4% to £10.9bn, as an 11% decline in equipment revenue...

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Underlying revenue declined 4% to £10.9bn, as an 11% decline in equipment revenue driven by fewer engine deliveries in Civil Aerospace offset a 7% rise in Services. However, cost saving together with the absence of Covid-related charges meant the group swung from a £2.0 bn underlying operating loss to profits of £414m.

CEO Warren East announced plans to step down at the end of the year and the group is currently looking for a successor.

For 2022, management forecast low-to-mid-single digit revenue growth with operating margins roughly flat. The group expects modestly positive free cash flow, with the bulk coming in the second half of the year.

The shares were down 17.6% following the announcement

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Our view

Rolls Royce's (Rolls) main business is producing and servicing aircraft engines, increasingly for bigger widebody planes (passenger planes with two aisles). That's been a terrible place to be over the past two years.

But a massive restructuring effort has set the stage for recovery. Three of four disposals have competed, with the final business to get the boot later this year. 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.

The leaner organisation has shown signs of strength. Last year the group saw £4bn of cash walk out the door, this year that's down to £1.5bn. Almost all divisions boasted operating profit improvements thanks to the new lower cost base and debt also made its way markedly lower. Barring any significant disruptions, the group expects to be free cash positive this year.

It's been a commendable transformation under difficult circumstances, to CEO Warren East's credit. That's probably a big part of the reason investors reacted so negatively to his planned departure at the end of the year.

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, contributing less than a third to revenue but delivered higher operating profits than the business as a whole. 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 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 genuinely impressed by the group's about face. But there's still work to be done, and with Aviation still hobbling along it's going to be a bumpy ride. With no dividend on offer to make the wait more palatable, shareholders should be prepared to stomach some turbulence.

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Full Year Results (underlying, currency adjusted)

Revenue in Civil Aerospace fell 10% to £4.5bn, as equipment revenue fell 29% due to fewer engine deliveries. Second half engine flying hours (EFH) rose 57% from 2020 as covid restrictions eased. Service revenue rose 6% as the group caught up on long term service agreements. Restructuring savings together with the increased service revenue helped operating losses narrow from $2.5bn to £172m.

Equipment and service revenue both rose within Defence, bringing the division's total 5% higher to £3.4bn. The group added £2.3bn to its order book, including a $0.5bn contract with the US Department of Defence that's expected to deliver a total of $2.6bn in equipment sales in the future. Operating profits rose 3% to £457m as a shift toward higher-margin spare part sales offset a 28% increase in research and development spend.

Easing covid restrictions helped the Power Systems order book grow £3.3bn as demand outstripped supply. Revenue rose 3% to £2.7bn, driven by a 10% rise in aftermarket services. Operating profits rose 37% to £242m, driven by manufacturing efficiency, higher-margin spare parts sales and increased volumes.

Revenue in New Markets was £2m, coming entirely from Rolls Royce Electrical, which develops electric aircraft. Rising capital expenditure on product development meant the division posted a £70m operating loss.

The group's completed three of its four planned asset sales, with the final largest sale of ITP Aero expected to complete in the first half of 2022. Total proceeds are expected to be around £2bn and will be used to pay down debt.

Free cash outflow for continuing operations was £1.5bn, an improvement from £4.3bn last year. This was largely due to cost saving and higher profits. The outflow meant net debt rose from £3.6bn to £5.1bn.

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.

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
Laura Hoy
Laura Hoy
ESG Analyst

Laura is part of HL's ESG analysis team, working to offer research and analysis to help with sustainable decision making. She also works with other parts of the business to help integrate ESG.

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Article history
Published: 24th February 2022