Rolls Royce Holdings Plc (RR.) Ordinary 20p Shares
HL comment (13 May 2021)
So far this year, the group is trading in line with expectations. In the four months through April, large engine flying hours (EFH) were around 40% of 2019 levels. Management still expects to turn free cash flow positive at some point in the second half.
The group has made "good" progress on its aim to deliver £1.3bn in cost savings this year and plans to sell ITP Aero are progressing with "an encouraging range of interested parties."
The Power Systems and Defence divisions continue to perform resiliently, supported by government demand.
The shares were broadly flat following the announcement.
Rolls Royce's 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 in a pandemic.
A year into the global pandemic, Engine Flying Hours are at less than half of normal levels. They're expected to recover to just 55% of 2019 levels in 2021 and 80% of 2019 levels in 2022. It will take years for the group just to get back to square one, let alone stage a fully-fledged recovery.
The lack of flying hours means customers aren't having their existing engines serviced, but also that they don't have the money (or need) to buy new ones. Coupled with very large, very fixed costs, and the net effect was a £4.2bn cash outflow in 2020. Cash is expected to continue sliding out the door until the middle of 2021, when management's base-case scenario predicts a shift into the black.
Enter the biggest restructuring effort Rolls has ever undertaken. Just over half of the 9,000 job cuts the company promised happened last year, disposals are underway, and investment has been funnelled away from Civil Aerospace - previously the core division.
The group ended the year with £9bn worth of liquidity, so we don't have immediate concerns on this front - though that cushion came at a cost. Rolls is 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.
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. But as Defence makes up less than a third of the group's overall revenue, this is a small glimmer of hope in an otherwise gloomy story.
At one point we thought the defence business might end up on the block, with cash from a sale needed to keep the rest of the business afloat. Fortunately that danger seems to be receding as the group moves forward with the disposal of ITP Aero. 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 - in both defence and Civil Aviation. 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.
Ultimately, the group is at a cyclical low point and while it appears the worst is over, a lack of a clear profit trajectory means the future remains uncertain. The bull case focuses on specialist products and services and they're long-term attractions. We could be looking at a very different business on the other side of all this, and without a dividend to make the wait more palatable, shareholders should be prepared to stomach a bumpy ride.
Rolls Royce key facts
- Price/Sales ratio: 0.7
- 10 year average Price/Sales ratio: 1.1
- Prospective dividend yield (next 12 months): 0.1%
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.
Full year results 11 March 2021 (underlying figures unless otherwise stated)
Full year underlying revenue fell 23.9% to £11.8bn, driven by a £3bn decline in Civil Aerospace revenues. The group reported a £2bn underlying operating loss, which doubled to £4bn loss before tax once financing and unused hedging positions are taken into account.
Due to restrictions relating to the group's loans, Rolls Royce cannot return any cash to shareholders before 31 December 2022. After that the group can only pay dividends if it meets certain criteria.
The group expects Engine Flying Hours (EFH) to rise to 55% of 2019 levels in 2021. That should allow Rolls to turn cash flow positive during the second half. EFH are expected to reach 80% of 2019 levels in 2022 at the earliest.
Civil Aerospace delivered 264 widebody engines in 2020, down from 510 in 2019. Revenue fell 37% to £5.1bn, driven by a 43% decline in services and a 29% decline in equipment sales. Aftermarket revenues were lower as large engine flying hours came in at 43% of 2019 levels. The lower volumes fed into a £2.6bn operating loss, which included £1.3bn in one-time Covid-related charges.
Power Systems revenue of £2.7bn fell 17% on an organic basis. That reflects a fall in industrial and power generation revenues, while marine was propped up by government demand. Equipment sales were down 21% while Services showed a 6% decline. That fed into a 52% decline in operating profits, to £178m. Power Systems revenue is expected to recover to 2019 levels by 2022.
Defence revenue increased 4% to £3.4bn, which was a product of higher aftermarket service revenues for vertical take-off system 'LiftSystem' and an increase in international EJ200 engine sales for the Eurofighter Typhoon. Operating profit rose 8% to £448m due primarily to increased sales volumes and modestly lower research & development and administrative costs.
The ITP Aero business saw revenue fall 26% to £705m, due primarily to falling engine sales on civil programmes. Service revenue increased 8%. Lower volumes fed into a 39% decline in operating profits to £68m.
The problems in Civil Aerospace was primarily responsible for the group's free cash outflow of £4.2bn. Rolls Royce finished the year with net debt of £3.6bn compared to £993m in 2019, with significant cash outflows mitigated by the £2bn rights issue completed during the year. At the end of 2020, the group had access to £3.5bn in cash and £5.5bn in undrawn loans.
In the current financial year, Rolls Royce expects a free cash outflow of around £2bn, with cash flow expected to turn positive during the second half. If EFH recover beyond 80% for a full year (expected in 2022 at the earliest), the group expects to achieve free cash flow of £750m. The group is targeting at least £2bn from disposals by early 2022, including the sale of Civil Nuclear Instrumentation and Control and Bergen Engines businesses.
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 disclosure for more information.
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