Insight: Friday 10 July 2020: Rolls-Royce signals 7 years until full recovery

News:

The financial picture at Rolls-Royce, as with every other commercial aviation entity, has turned bleak amidst the current global pandemic. The company was estimating a positive cash flow of £1 billion for this year but is now expecting a cash outflow of £4 billion, of which £3 billion will be from the first half of the year.

The company has, like Boeing, been beset with product problems. Those were compounded by the pandemic that reduced new orders for engines and decimated maintenance revenues as aircraft stopped flying. The company has suspended dividends, announced 9,000 job cuts, and accepted a £2 billion government loan, and still may need to raise another £2 billion in equity capital that would dilute its shareholders further.

Rolls-Royce builds engines primarily for wide-body airliners, and powers about 38% of the current wide-body fleet. The razor and razor blade business model for aircraft engines means that Rolls-Royce loses more than £1 million on each engine it sells, making up the revenue shortfall in the sale of spare parts and services. But with aircraft not flying, those service revenues have dried up, exacerbating an already dicey financial position. The company now believes that a full recovery may take up to 7 years to complete.

Analysis:

Rolls-Royce is in deep financial trouble. But rescue from an international merger is unlikely, as the British Government retains a “golden share” from a bailout of the company in the 1970s and would block an international takeover. While it would make sense for Pratt & Whitney, which builds the GTF for narrow-body aircraft but has no new technology wide-body engine, to acquire Rolls-Royce which offers only wide-body engines today, such a combination is politically unlikely. We have thought it about before.

The technical difficulties with the Trent 1000 engine, while expensive, are showing progress. The company has completed the backlog of overhauls related to the Trent 1000 durability issues and has achieved the target to reduce the number of related aircraft on the ground (AOG) to single digits. Rolls-Royce is progressing well with the type test of the replacement high-pressure turbine blade for the Trent 1000 TEN, the final durability issue to be fixed, and remains on track for its incorporation into the fleet by June 2021. Nonetheless, the cash flow issues resulting from the problems have been substantial and will continue into next year.

The outlook for the company, which plans to reduce its cash shortfall from £3 billion in the first half to £1 billion in the second half, will reflect reducing inventories, cost-cutting, and a gradual resumption of flying hours and services revenue over the next six months. Even as such, the company is projecting only 70% of pre-pandemic flight hours for 2021, meaning reduced maintenance revenues that will heavily impact financial performance.

Insight:

Rolls-Royce is an essential component of the British defense industry and is likely too big to fail. It has been bailed out by taxpayers in the past, is the recipient of government loans today, and could again be bailed out if projections for improvement do not pan out if the pandemic continues longer than expected. Today, liabilities strongly outweigh the company’s assets, and its market value has fallen to 1/4th of its former value.

The company is vital to Airbus, as it is the sole source of engines for the A330neo and A350XWB, Airbus new technology wide-body programs. While the Trent 1000 also powers the Boeing 787, that market is shared with GE and customers have a choice of engines. The survival of Airbus in the wide-body market is totally dependent on Rolls-Royce continuing to build and support aircraft engines.

The outlook for Rolls-Royce is bleak, but we’ve seen this before. The bailout in the 1970s led to a resilient competitor that gained back market share and continued as a major player in the aerospace market and was a major source of exports for the UK. Rolls-Royce has a plan in place to recover if everything works right and the world recovers from the pandemic as hoped. But the company will be weaker financially, and the question is whether the Advanced and UltraFan developments for a new narrow-body engine will need to be suspended or pushed back to conserve cash in the near term. If so, the impacts from the pandemic could last for decades rather than years, and Rolls-Royce would remain a niche wide-body player rather than produce engines for any size aircraft.  A smaller and more focused Rolls-Royce is a likely outcome as it emerges as a weaker player in the wake of the global pandemic.