Rolls Royce Holdings Plc (RR.) Ordinary 20p Shares
HL comment (5 August 2021)
Revenue in the first half fell 9% to £5.2bn, as declines in Civil Aerospace outweighed a stable performance in Power Systems and growth in Defence.
Rolls Royce swung from a £5.4bn loss in 2020 to profits of £393m, helped by cost savings achieved through the restructuring and a £280m tax credit. Stripping out the impact of derivatives, underlying profits were £147m.
The group still expects to turn free-cash positive in the second half, bringing the full-year free cash outflow to around £2bn.
The shares were up 1.9% following the announcement
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 in a pandemic.
With the pandemic continuing to weigh on the travel sector, Engine Flying Hours are at less than half of normal levels. When we last heard, they were 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, the net effect was a £1.2bn cash outflow in the first half. Cash flow is expected to turn positive this half though, when management's base-case scenario predicts a shift into the black.
Enter the biggest restructuring effort Rolls has ever undertaken. 8,000 of the 9,000 job cuts the company promised have happened so far, disposals are still underway, and investment has been funnelled away from Civil Aerospace - previously the core division.
The group ended the half with £7.5bn 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.
Seemingly 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: 0.74
- 10-year Average Price/Sales ratio: 1.07
- 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.
Half Year Update (Underlying & Organic)
Underlying revenue in Civil Aerospace was down 13% to £2.2bn, as a recovery in service revenue wasn't enough to offset a 39% decline in engine delivery volumes. Underlying operating profit improved by £1.9bn to £39m, helped by the restructuring programme which is cutting the division's cost base by a third.
An uptick in both service and original engine sales meant Defence revenue rose 17% to £1.7bn as some spare engine and parts sales typically realised in the second half were brought forward. Cost control coupled with higher-margin sales helped underlying operating profits rose 35% to £269m.
Power Systems reported a 4% revenue decline to £1.2bn, reflecting growth in aftermarket revenue but a 13% decline in original engine revenue, as expected. The rise in higher-margin aftermarket sales coupled with a reduction in R&D costs related to the timing of projects helped operating profit rise 26% to £41m.
ITP Aero, which Rolls is currently in talks to sell, saw a 20% revenue decline to £317m. Operating profits were £7m.
The group's restructuring plans are expected to deliver more than £1bn in savings this year, while its disposal programme is on track to achieve at least £2bn in proceeds with the planned sale of ITP Aero moving forward and Bergen Engines, valued at EUR63m, under agreement once again.
At the half, the group had access to £7.5bn in liquidity with no debt maturities (excluding ITP Aero) coming due before 2024. Net debt, excluding ITP Aero, increased by £1.4bn to £4.9bn.
The group had a free cash outflow of £1.2bn, reflecting a £0.6bn underlying improvement due to cost reduction and a stronger operating performance
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.
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