Rolls-Royce Holdings — Update 11 April 2016

It has been apparent for some time that the bull case in Rolls-Royce has been built around the cash-generative potential of the civil engine business. This arises as the installed base grows with an annuity of high-margin recurring revenues from the required servicing of the operational fleet to meet regulatory safety standards and maximise airline operating capability. While this did not always meet with the accounting wrapper applied to the division in terms of timing of recognition of revenues and profits, the general perception was that the underlying cash flow development was predictable and expected to grow. The mismatch of profits and cash was seen largely as an issue relating to the quality of declared earnings rather than cash valuation.

To a degree this factor is unaltered today despite the recent share price turbulence, which is in our view largely explained by a squeeze on both earnings and cash flow of both the Civil division and the overall group. However, we do not believe the overall core model for civil engines is broken at Rolls-Royce or in the wider engine market generally. Long term, we believe the company’s strengthened market position in the high thrust, widebody aircraft engine market served by its Trent product family will prove highly cash generative and grow strongly for many years to come.

These assumptions underlie our cash flow-derived valuations which indicate that the shares at present retain significant potential for the longer term.

So, what has happened to this bull case investment thesis in the recent past? Simply put there has been a confluence of cash flow reducing factors that generated the series of profit warnings, which consequently undermined sentiment for the equity. We feel many of these factors are likely to prove transient rather than structural, but they have highlighted two main issues at Rolls-Royce:

The new management team is now challenged with the task of addressing these issues and restoring confidence in the investment proposition.

After a shaky start with the incremental profit warnings in July and November, the full year 2015 results provided the first glimpses of the path to redemption. There was no additional warning, although the market continues to adjust mid-term expectations to the factors that are affecting earnings as the accounting treatments are altered to reflect the changed contractual arrangements affecting the new engine programmes. That is to say more unlinked long-term engine supply and support contracts compared to the linked accounting contracts that have been dominant in recent years. It should be noted that these treatments differ in how they deliver earnings into the P&L, but have no effect on the cash flow from the contracts. However, it is clearly a factor favoured by management as it should more closely relate earnings performance to economic cash performance.

As for the structure of the group, the CEO has been quite straightforward in saying that his review to date has been operational, highlighting operational inertia, inflexibility and excess fixed cost that the company continues to address. In the process there has been some overlap with strategic fit issues, which the company may start to address. However, this is not a new feature as the portfolio has seen significant alterations over the last 30 years, culminating in the exit of the narrowbody engine market and the disposal of the aero-derived compressor and power generation business.

The introduction of ValueAct to the board is seen by many as a catalyst for significant change to the strategy. Our view remains that alongside the Civil business it is important that the group retains other revenue streams that provide different cyclical cash flows to support the long-term investment cycle in civil engines. Without Marine, Defence and Power Systems over the last decade, and the receipts from Pratt & Whitney for IAE and Siemens for the power generation business, it is likely Rolls-Royce would be in far more difficulty today than appears to us to be the case.

As an investment, Rolls-Royce is long term in nature. The aeroengine model is structured to derive the cash value from the servicing element (aftermarket) of competitively supplied initial fit engines (OE). Investment returns from high front loaded expenditures are generated by these aftermarket revenue flows over decades. In the Civil division most of the expenses (and thus risk) are borne by the company, with returns from the aftermarket set much higher to generate a healthy overall rate of return. As discussed in our last note, this is reflected in the cash curves of the various engine programmes which we feel remain largely intact despite current headwinds. The level of risk for Defence is reduced by customer funding and involvement, with margins more balanced between OE and aftermarket. Marine, Power Systems and Nuclear are more product driven but retain significant service elements, and centre on long-term relationships with customers.

The success of Rolls-Royce’s Civil business is contingent on generating sufficient cash generative aftermarket revenues to fully fund the heavy investment and new product introduction cycles it will face as the markets and aircraft power requirements develop. This will be driven by a combination of platform opportunities and economic or environmental considerations.

In this regard, the civil business could still be considered relatively immature. Rolls-Royce’s success in achieving a 50% market share in its chosen market has yet to be translated into installed thrust and thus aftermarket revenues that would reverse the adverse cash dynamics. It would also lead to sustainable margin development comparable to its main peer GE.

However, it appears Rolls-Royce is travelling in the right direction. Installed thrust on current programmes has risen to 405m/lbs at the end of 2015 from 320m/lbs in 2010, a CAGR of 5.2% despite the dilutive impact of declining legacy programmes. As Trent deliveries more than double over the next three years driven mainly by the A350 programme, five-year CAGR should improve to at least 5.8% by 2020 despite our aggressive retirement assumptions for the rest of the engine fleet.

As new product introduction cash outflows reduce by the end of the decade Rolls-Royce’s Civil operations should arrive in a more stable market position. Higher margins and cash flows should then enable the division to self-sustain, as future projects such as a further Airbus A350 stretch or A380 re-engining programme are evaluated and possibly pursued.

Our view remains that new engine programmes equate to acquisitions for Rolls-Royce’s Civil business, with extended investment cycles but ultimately significant value creating potentials. Therefore, investors should be comfortable with Rolls-Royce continuing to invest in R&D and new programmes that arise. Thus while it may appear contrarian given the current situation, we would tend to regard recent share price declines as a potential opportunity for longer-term investors, once the current pockets of turbulence have been left behind.

However, it is clear that both the civil model and the group overall are carrying a lot of cash flow baggage in the near term. So where has the cash gone? In our view it is a coincidence of adverse factors in the civil division as well as cyclical declines elsewhere in the group, specifically Marine.

A number of factors are serving to consume cash in the Civil Aerospace division that manufactures and supports aircraft engines. In almost all cases these relate to the new product introductions or new engine developments that are in process or are coming to an aircraft near you soon, although some are regarded as legacy issues. There are a variety of issues in this category:

While the widebody aftermarket continues to grow, with improving cash flow implications, it is not a sufficiently large enough improvement to offset these adverse cash factors at present.

Other group cash flow impacts

Coinciding with these Civil requirements, other factors have reduced the overall group cash flow performance. This includes the cyclical reduction arising from the offshore market decline in Marine over the last few years. A recovery in the market and efficiencies should allow some improvement from FY17. Defence is also expected to generate less cash in the current year due to increased investment and the run out of costs on UK programmes where advance deposits have been received ahead of delivery. Longer-term cash generation for the division is expected to strengthen.

At the group level the outturn for FY15 earnings actually proved to be slightly better than the much reduced outturn we had anticipated. Stripping out a £58m intellectual property settlement in Other and a £19m R&D tax credit in Nuclear, both of which were unexpected and one-off, would have left underlying profit before tax at £1,355m compared to our forecast of £1,349m.

In addition, the free cash inflow for the year was better than anticipated at £179m. Whilst the final dividend was cut by only 50%, the indication that the interim 2016 payment would be cut by a similar amount suggests to us that the FY16 total will be half the level for FY14. The net debt position at the year-end was thus £111m compared to net cash of £666m at December 2014.

Civil divisional revenues of £6,933m (FY14 £6,837m) grew by an underlying 3% that was largely offset by a 2% currency impact. Underlying OE revenues fell by 3% (with a further 3% negative currency effect) and services revenue grew by 9% (FX added 1%) on an underlying basis, or 4% excluding the retrospective customer risk assessment benefit (see below).

There were significant benefits from retrospective contract accounting adjustments that are unlikely to recur. A total boost of £222m (FY14 £150m) to UPBFCT arose from:

A £65m profit was also recognised as the result of an impairment reversal of CARS relating to an improved in service experience for a customer on the Trent 1000 engine for the Boeing 787. The improvement largely related to the outlook for future maintenance costs. It also led to the capitalisation of £22m of CARS within the year that would otherwise have been impaired.

Divisional gross margin was 22.0% (24.5% in 2014), or 17.9% stripping out the £287m of non-recurring elements mentioned above.

Restructuring costs were some £75m lower at just £7m but this benefit was more than offset by an increase in expensed R&D of £65m and a £13m increase in commercial and administrative costs. Joint ventures and associates contributed £11m to divisional underlying profit before financing.

In Defence profits benefited from a £107m uplift to long-term contracts including a non-recurring £40m. Excluding the non-recurring element gross margin fell to 26.5%, slightly lower than the prior year. While the order book fell by 5% to £4.3bn it still represents over two years of sales and with over 60% of sales in service and support of the fleet, prospects look robust. Issues surrounding the A400M still need to be fully addressed, but do not look likely to undermine the long-term outlook.

Power Systems performance was resilient despite weaker volumes in some sectors such as oil & gas (-5% on constant currency) and government. Sales fell by 12% to £2.39bn although 75% of the drop was currency related. Gross margin fell to 26.6% from 27.3%, reflecting the 3% organic declines in sales combined with some adverse mix. Order intake of £2.5bn almost matched the £2.6bn achieved in 2014, and the year-end order book was just 2% lower at £1.93bn.

A 26% decline in Marine’s order book reflected the sharp declines in offshore markets. Merchant markets were also subdued and naval remains relatively robust. The year-end backlog was £1.1bn, and order intake at £997m was down 45%, Revenues fell by 23% to £1.3bn, of which around a third was FX related. OE revenues fell by 28% while more resilient services sales fell by 14%, reflecting lower activity and deferrals of overhauls. Gross margin fell to 19.6% from 24.9% as a result of the weaker revenues, pricing pressure and cost under recovery. Whilst operating costs fell, the contribution to underlying profit before tax still fell to £15m from £138m.

Underlying performance at Nuclear was resilient although it benefited from a £19m R&D tax credit. Submarine work and good demand for instrumentation and controls drove a 9% revenue increase, but gross margin fell to 16.2% (from 18.7%) due to increased costs on certain low margin contracts.

While the long-term investment case remains intact, in our view, near-term profit headwinds persist and adverse impacts on earnings in FY16 and to a lesser extent in FY17. While the growth of profitable and cash generative aftermarket revenues continues, in the next couple of years the negative original equipment (OE) effects will outweigh that positive.

As Rolls-Royce enters its latest period of new civil engine product introduction on the Airbus A350 with the Trent XWB, returns face a period of dilution. Early launch customers receive additional discounts to mitigate risk of underperformance during the initial operational phase.

The increase in unlinked accounting of the OE sales and the long-term service agreements means that losses incurred on the initial supply of these engines are capitalised as contractual aftermarket rights (CARs – formerly recoverable engine costs), and amortised over a15-year period. The change arises because on the A350 programmes the contractual arrangement is that Rolls-Royce is supplying the engines to Airbus rather than direct to the airlines, with the long-term service agreements still negotiated with the airlines. These early unlinked OE revenues are thus booked with zero profitability. In contrast, the linked contracts that currently dominate the Trent OE revenues have a positive margin applied as part of the overall airline contract profit even if an initial cash loss is incurred on delivery. The loss is effectively spread over the life of the linked service agreement.

This factor will depress profit margins as both variants of the Trent XWB move through launch phase with dilution rising in 2016 and 2017. As volumes increase the mix of unlinked deliveries will rise from c.35% of OE deliveries in 2015 to just over 70% in 2020 before stabilising. It is exacerbated by additional investment in the new Trent 7000 to power the Airbus A330neo and to improve the performance for the Boeing 787 with the Trent1000TEN. It should be noted that the underlying cash generation remains the same regardless of the accounting treatment.

However, the new product disruption also depresses pricing for product that is likely to be replaced but for which an element of demand is still required to mitigate overall supply chain inefficiencies in a run out phase, specifically the Trent 700 on the current A330ceo. What were very profitable engines under the linked accounting on a successful and mature programme now suffer from both a drop in volume and pricing as transition to the newer aircraft (A330neo) is implemented.

Together with weaker legacy widebody (RB211 engines on the Boeing 747, 767 and Trent engines on the B777 and A340-500/600), regional and bizjet market factors, it was these headwinds that Rolls-Royce had previously warned about through 2015. While the drag will increase in FY16, the initial effect was apparent in FY15 results.

In the longer term the challenge for Rolls-Royce remains unchanged; to execute delivery of the healthy order book that stood at £67.0bn (up 6% y-o-y), converting it into high margin aftermarket revenues and cash flow. Representing almost 10x current divisional sales, with almost half attributable to the Trent XWB programmes, the opportunity is self-evident.

The long-term prospects for Defence remain positive, with healthy positions in military aircraft engine markets for transport, trainers and combat platforms. It also generates over 60% of sales from services which tend to be recurring and very long term. The global defence spending environment is improving, but cycles for military engines are very long term so we see little change to current programme new delivery expectations over the remainder of the decade. However, while 2016 should be stable, profits will not benefit from the £40m non-recurring uplift taken in 2015. As a result profitability is expected to be somewhat lower on stable revenues.

The Power Systems division has remained more robust than many expected, and this is aided by the quite diverse range of markets served by its diesel engines and the resilience of the service revenues. While some markets are under pressure none of them are of a significant scale, and it retains healthy order books in other key segments. The outlook for the timebeing remains one of consistency rather than growth, with modest growth in sales and profits expected in 2016.

Despite the declines, oil & gas related offshore markets still accounted for 56% of divisional sales in FY15. The combination of continued weakness in this market and the cost of the rationalisation initiatives intended to mitigate its impact, will lead to a £75-100m decline in divisional profits in 2016. We would expect to see a significant improvement as the net benefits of restructuring appear in 2017. Naval and merchant vessel exposures are expected to remain relatively stable.

The nuclear division is expected to be relatively stable in the coming year, although the £19m tax credit should not recur. The large naval content for Royal Navy submarines, which generates substantial support revenues, should underpin profitability and cash flow at current levels until the continuing investment in civil nuclear projects starts to bear fruit and grow. The unsolicited proposal of mini reactors for civil power generation purposes utilising knowledge and experience from the submarine programmes is an example of continued innovative thinking throughout RollsRoyce.

Strategic focus priorities in 2016 have been set as:

Restructuring programmes therefore continue to initiate substantial cost reductions in Aerospace (£80m net benefit expected in 2016) and Marine. The net benefits of these programmes should be fully realised by the end of 2017 and total £120m. Defence will be helped by the significant investment in a new facility with a footprint reduction in Indianapolis.

The new transformational programme initiated by the new CEO, Warren East, has already seen around half of the expected £150-200m of targeted savings identified. Aimed at increasing operational flexibility, simplification of structures and reducing fixed costs, the enduring cost saving should be fully realisable in 2018. There may be more to come, but our view remains that a more positive confluence of market, self-help and mix will significantly improve returns by 2018.

Fundamentally the reduction in near-term cash flows from Marine due to cyclical decline, and at Civil due predominantly to new product introductions are producing an additional reduction in cash based valuations. After rebasing our forecasts post the FY15 results, our valuation has declined to 808p/share. However, we do expect this to increase as the current investment phase in the Trent XWB, Trent 1000TEN and Trent 7000 engine programmes progresses and Marine recovers.

Our DCF methodology caps growth in cash flow development in six years. In our view, it remains inherently conservative as aftermarket revenue and cash flow growth in Civil should last for decades after OE deliveries end on any specific engine programme. Therefore, we have curtailed the long-term growth annuities of aftermarket streams that form the crux of the investment case. As the DCF rolls forward the currently depressed cash flows should be replaced by growth in the incoming years, enabling fair value to expand once more.

The performance in FY15 did not alleviate the pressures coming to bear on FY16. However, in the absence of a widely anticipated warning about Power Systems, our underlying outlook for the current year is broadly unchanged.

With similar headwinds persisting in 2017 we do not expect any substantial recovery in profitability, although we do expect moderate growth from the Civil aftermarket and cumulative restructuring benefits in both Aerospace and Marine. We would expect free cash flow to turn modestly positive although there is likely to be modest increase in net debt due to the reduced dividend payments.