Rolls-Royce Holdings — Update 17 November 2015

Given the adjustments already announced in the current year, the Q3 statement was never likely to be much more than incremental bad news, with some adverse trends in more mature civil aero engine markets and macro influences on industrial activities the primary drivers. While current-year guidance is maintained, these factors are now expected to have a greater adverse influence on FY16 performance than previously expected, creating additional headwinds of up to £350m.

The principal affected areas are the offshore marine and legacy-widebody, regional and corporate jet markets. The declines in oil & gas investment markets now appear likely to be prolonged and the impact on global shipping markets and declining global trade levels with slower growth in China both hurt Marine demand.

Guidance for the current year was maintained, albeit at the lower end of the range in terms of profitability. The developing adverse trends in more mature civil aerospace markets are being largely offset by cost savings and other positive developments.

As a reminder, FY15 group level guidance ranges are (our current forecasts are in brackets):

The £300m profit headwinds for FY16 already announced in July are summarised as follows:

Reflecting this guidance, FY16e market consensus had been PBT of £1,053m.

The incremental profit headwinds of up to £350m for FY16 are:

While not explicit, cash flow guidance appears to be more robust, with a lower rate of working capital drag expected next year helping to offset the headwind effects.

Many of the headwinds are expected to continue to adversely affect performance beyond FY16.

Civil

Civil aero profitability had already been adjusted by 6 July guidance update that indicated a £300m impact on FY16 profitability, driven primarily by falling T700 deliveries (£250m negative headwind). The balance was largely related to the lower levels in the medium thrust segment powering regional aircraft and bizjets. The T700 impact and adverse unlinked:linked contract mix headwinds remain as previously indicated for FY16.

The additional adverse factors in Civil have been developing since July. Lower regional and business jet activity is driving the £100m reversal in profit next year, on top of the £50m already indicated for FY15. Corporate engine original equipment (OE) deliveries tend to sustain above-average profits, as do the aftermarket sales in both regional and corporate markets.

Adverse market developments for legacy-widebody aircraft, which produce high-margin revenues, are expected to affect profits by £100-150m. These older fleets are currently suffering from an accelerated pace of parking and lower fleet utilisation rates as the number of new efficient aircraft entering service increases. The impact is being felt more directly during the quieter traffic season but appears exacerbated by a blip in demand arising from macro uncertainties, with airlines seeking to match capacity to demand. The fleets affected are likely to include early Trent types, including Trent 800 on B777, with service agreements likely to be a mix of long-term service agreements and more immediate time and maintenance agreements. The RB211 fleet may also be affected, although revenues here have been falling sharply for several years on the limited B747 and B767 fleets. It may be an increasing issue for the larger B757 fleet as B787 and A350s enter service.

Land & Sea

In Land & Sea, Marine management is now assuming a further 15-20% decline in offshore sales next year as oil & gas investment remains lower for longer, creating a further £75-100m profit drag. The naval segment appears relatively robust at present, including its aftermarket.

While Marine has been progressively addressed, the effects on Power Systems, which is predominantly the diesel reciprocating engine business (formerly Tognum and RR’s Bergen engine unit), still appear muted with a broader portfolio of exposures providing greater stability. The engines it supplies also drive some marine applications as well as areas such as fracking pumps for the oil & gas market, but areas such as power and governmental are growing. The record half-year order book appears to have developed favourably during Q3, which presumably is supporting the perhaps surprisingly stable outlook for the division.

Civil nuclear is a much longer gestation industry and currently has relatively limited influence on group results, although submarine activity remains relatively robust and profitable. The Defence Aerospace operation remains pretty robust with a >60% aftermarket contribution to sales, as does the naval element of Marine (surface ship propulsion and support around one third of Marine sales).

One of the factors hurting the share price is undoubtedly a lack of positive near-term catalysts. The company spends much of its time explaining the incremental effects, which are generally negative, and underlines that known near-term positives tend to be offset by already known mitigating factors. For example, the increased contributions from the growth of the Trent installed base and its associated aftermarket in FY16 are offset by a lower rate of positive contract releases that are being seen this year.

Management continues to point to margins rising to previously expected levels over the next five years following the ramp-up in production of the new Trent engine programmes, which will see Trent output double to 600 engines per year.

The cash flow conversion rate should also follow, accelerated by the shift to unlinked contracts on the Trent XWB programme. Management expects the linked:unlinked proportion of engine deliveries to shift from 33% this year to 40% in 2016 and 80% by 2020 as these deliveries increase. At that point cash conversion of around 80% may prove to be the norm, rather than an aspiration.

As a reminder, Exhibit 1 highlights the market opportunities that each segment addresses. In each case these are substantial. Successfully executing strategy into these markets should be a critical verification of management credentials.

In light of the additional financial headwinds, the board will also review the policy with respect to shareholder payments. Changes, if any, are to be announced at the usual time with the preliminary results in February. Factors likely to be under consideration by the board are:

The much lower profit basis, which the announcements have delivered, now clears the way for management to reset expectations for the group's longer-term prospects. Undoubtedly, the guidance reductions will remain under scrutiny. However, the new CEO has also presented some initial conclusions from his operational review that should be presented in more detail on 24 November at the capital markets day. However, the full details will not be presented for several months due to ongoing reviews and the need to manage consultation processes first.

Specifically he has pointed to an incremental programme of major structural changes that will be implemented in 2016. The current performance improvement plans being executed in Aerospace and Marine remain on track to deliver targeted savings. The new initiatives, yet to be finalised, are expected to generate savings of £150-200m per year to be fully realised by the end of 2017. Costs and timing rely on consultation process so should be available by the preliminary results in February. Capex and R&D are to be maintained, at least in absolute terms.

At the half year, management stressed that the review being undertaken by Warren East following his appointment as CEO would be operational and not strategic. Broadly speaking, we take this to mean that the overall structure and portfolio of the group is deemed to be consistent with the company's long-term ambitions. However, as indicated on the Q3 call, it was almost inevitable an assessment of the value of activities to the group would develop.

Recent reports suggest that the new CEO is still content with the existing strategy, despite supposed pressure from the now largest investor, ValueAct, which may favour a more focused philosophy. In our view, both sides can be argued, with a demerger route our favoured method of dealing with any of the major units while maximising shareholder value.

Our view remains that Rolls-Royce is a company that finds itself in an unfortunate situation; its investments generate returns over decades, not quarters. It is easy to criticise investments in areas such as Marine, when performance is cyclically depressed. It is therefore also easy to forget or be unaware of the cash it was generating just a few years ago. While we never understood the apparent interest in Wärtsilä, given a lack of cost synergies, we do understand the company's desire to be exposed to alternate cash cycles other than those of the aerospace industry.

We applaud decisions to exit businesses that are strategically constrained if terms are adequate. In this regard, the disposal of the IAE interest, the sale of its share in the RTM322 helicopter engine programme and the divestment of the industrial aero-derived gas turbine operations to Siemens all, in our view, created value for shareholders. The events also served to highlight the market's fundamental undervaluation of those programmes' long-term cash streams.

Previous managements have made some apparently poor investment decisions in the past; tidal power and flat pipe fuel cells being two recent examples. However, in times of depression the notion of cutting and running is a soft option, and often detrimental to shareholders.

RR's management is holding an investor day in London on the afternoon of 24 November. The meeting follows a year that appeared to lurch from one crisis to another, with little positive sentiment able to be created at any point. We would point to share price performance as evidence of the dramatic collapse in confidence of what we still believe to be an undervalued, long-term, cash-generative model, now rated to offer growth at a reasonable price (GARP).

We believe the market is looking for an improved understanding of the long-term dynamics of the strategic model, while proving competence in managing the near-term challenges across the divisions. If successful, a rebuilding of confidence should begin, which ultimately will see returns improve and the rating increase once more.

We believe management is likely to be targeting several goals, which may include:

Likely outcomes are

Our DCF valuation for Rolls-Royce, which caps growth after six years, still delivers a value of over £10 per share, even if rolled forwards to a FY16 basis. Such assumptions do not reflect the long-term cash generation growth expected from the new Trent programmes, with higher thrust deliveries over the remainder of this decade. Thus, we still believe this highlights a clear mismatch between the market’s short-term risk perspective and the civil aero engine model's fundamentals.

We are reinstating our forecasts reflecting the latest guidance from management, which removes a further £350m from FY16 estimates.

The near-term pressure on civil margins is expected to abate as we progress towards the end of the decade. This should be driven by Trent aftermarket growth and an improved mix as the transition from OE-linked aftermarket contracts on the T700 to unlinked contracts for the Trent XWB and T7000 for the A330neo continues.

Additionally, the pressure on Marine is clear, and management's actions to reduce cost are only likely to be evident once the market demand has stabilised, which is not likely until FY17. We remain of the opinion that volatility in the other three divisions is likely to be more muted.

Management has stated that margin expectations when the transition is complete are likely to remain unaltered, although we do not now expect these to be achieved until 2020 at the earliest.

Management has also stated that cash conversion should rise to 80% as the transition to the new programmes and overall Trent volume ramp-up completes. In combination, these factors imply substantial future free cash flows. However, market confidence in these elements needs to be rebuilt for valuations to start to trend towards the implied cash values.