In 2016 the Rolls Royce CEO took the decision to execute a turnaround plan that saw underperforming areas trimmed back and the business focus on key growth areas of civil aviation and maintenance.
At the time it seemed the perfectly sensible thing to do with airlines expanding their fleets, and switching to new greener and leaner models of aircraft.
Soon after this it became apparent that its Trent 1000 engine, which powered the Boeing 787 Dreamliner was starting to develop problems, with cracks forming on the turbine blades, the costs of which started to spiral out of control, causing the company to post a £2.9bn loss in last year’s full year numbers. To compound this there appears to be another issue with this power unit in reports yesterday that suggested a problem elsewhere, within the turbine itself.
In 2018 this strategy of focussing its energies on civil aviation started to develop further problems, with the decision by Airbus to stop production of its A380 aircraft, resulting in further write-downs, of nearly £250m.
Recent events due to Covid-19 have compounded these problems as the wholesale grounding of aircraft across the world, and its customers taking steps to delay or cancel future aircraft orders, saw its revenue base clobbered hard.
The collapse in air travel has seen nearly half of its projected revenue disappear, as airlines ground their fleets, and the various travel bans bite.
In order to shore up its finances and preserve its cash flow the company had to defer bonuses for its CFO and CEO, pull the dividend for the first time since 1987, as well as securing an additional $1.5bn revolving credit line in April, in addition to the $2.5bn it secured in March.
Throughout all of this, the company also announced plans to cull 9,000 jobs in its civil aerospace division, out of a global workforce of 52,000. These plans drew the ire of the trade unions, however if the cash isn’t coming in and isn’t likely to either, furloughing staff merely delays the inevitable.
It is these concerns about the long-term durability of the company’s aerospace division, against a backdrop of much lower spending from Boeing and Airbus, that caused investors to take fright last Friday on reports that Rolls Royce was looking at reinforcing its balance sheet further by raising additional capital, or disposing of some of its assets with ITP Aero, its Spanish operation one likely option.
There was no mention of raising additional capital in todays’ Q2 update which has seen management say that they expect a better performance in the second half of the year.
Good progress has been made in reducing one-off costs with £300m achieved in H1, with another £700m expected by the end of 2020. The company also said it would be taking a charge of £1.45bn over the next 6 years, in respect of reducing the size of its hedge book, with £100m of that charge being taken this year and £300m in 2021 and 2022, and then £750m spread over 2023 to 2026.
The company also said that they had pro-forma liquidity of £8.1bn, including an undrawn credit facility of £1.9bn, and commitments for a new 5-year term loan facility of £2bn underwritten by a syndicate of banks and a partial guarantee from UK Export Finance.
With airlines likely to remain in defensive mode for at least another 12 months Rolls Royce cash flow is likely to remain constrained for a while yet, with full year revenues look set to be £4bn lower than last year, and unlikely to improve much in 2021.
In a sign that life can come at you fast, it was only at the end of February that CEO Warren East was proclaiming that free cash flow would be positive to the tune of £1bn by the end of this year.
Given recent events the company won’t even get close to that, with current estimates expected to see a total cash outflow of approximately £4bn.
While the defence business has remained resilient, the civil aerospace division is likely to remain constrained for some time to come, and while wide body engine flying hours are showing signs of picking up, they are still down 50% in the first half of this year.
As long-haul flights have started to increase in China, and the Asia Pacific region this figure should improve in the second half, however it is unlikely to improve significantly with flying hours expected to be down 55% over the rest of the year, and only at 70% of 2019 levels in 2021.
In terms of deliveries Rolls Royce continues to plan for 250 wide body engine deliveries in 2020, however as Boeing and Airbus have found out recently, and Airbus announced this morning, new orders are becoming hard to come by, and that’s before we consider the prospect of further cancellations, as airlines cut costs.
Rolls Royce defence has continued to perform well, last year the company won a new £350m contract from the Ministry of Defence to maintain and repair the engines of RAF Typhoon aircraft. Last month the company also won a host of US Navy contracts totalling $115.6m to build a variety of engines, propulsion units and services.
Today’s update goes some way to alleviating investor concerns about the company having to raise extra capital in the short term, however it is clear that a lot of things will have to go right over the next 12 months, for these concerns not to come back. There is also the prospect of further job losses, unless management can get better control of the company cash flow, with management targeting £750m of free cash flow by 2022.
For a look at all of today’s economic events, check out our economic calendar.
By Michael Hewson (Chief Market Analyst at CMC Markets UK)