Rolls-Royce, Emerging From The Clouds
Edison | Feb 16, 2017 04:24AM ET
Rolls-Royce Holdings PLC (LON:RR)'s underlying performance in FY16 was ahead of both its own and market expectations. Media focus on the non-cash £4.4bn headline FX loss is missing what looks to be the basis for optimism. As the civil model starts to move from investment in engines for the A350 and A330neo into the aftermarket delivery phase over the remainder of the decade, we think cash flow is likely to improve, particularly if supported by an eventual recovery in Marine.
Establishing a base
After three years of turmoil, Rolls-Royce appears to be finally creating a baseline from which to re-establish its investment credentials. In FY16 it beat expectations comfortably at the adjusted earnings level and generated an unexpectedly positive cash flow. With modest progression guided for in 2017, it increases confidence that the long-term cash flow growth proposition from the large civil aircraft engine aftermarket is achievable. This should progressively accelerate once the heavy investment phase and ramp in new civil engine products wanes. This could commence from H217 as Trent XWB launch pricing discounts diminish.
Enabling evolution
We suspect management continues to constrain optimism, perhaps in part due to the non-cash impact of IFRS 15 on earnings from next year and clearly in light of additional cash burdens. These include the phased £671m settlements with the SFO, the DOJ and the Brazilian investigation authorities, as well as the purchase of the ITP minority for €620m in eight quarterly payments once completed. However, prospects of more than £1bn of free cash generation by the end of the decade remain hugely supportive. The promised strategic review has yet to be properly initiated due to the prioritisation of operational issues in recent months. It should now commence and ultimately clarify longer-term positioning and goals.
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