Fitch Affirms Rolls-Royce at 'A'; Outlook Stable
The affirmation reflects the company's recent and expected financial performance meeting Fitch's expectations and in line with the 'A' rating. Earnings and cash flows in 2015 are likely to be somewhat lower than in 2014, but we expect restructuring measures to lead to a recovery of key metrics over the medium term. In particular, short-term pressure on credit metrics driven by transition to new programmes and weakness in the marine division will be limited by the suspension of the GBP1bn share buyback programme at only GBP500m. The rating will face pressure if the company's free cash flow generation does not return to historical levels from around 2018, in line with our expectations of position in the product life cycle.
KEY RATING DRIVERS
Adequate Financial Metrics
Rolls-Royce has had a continuously stable financial performance. Despite the weaker outlook for some of the company's non-aerospace end-markets such as oil and gas and marine, Fitch expects the company's overall credit profile to be only slightly affected, and that it will maintain a financial profile broadly consistent with the rating. Earnings and cash flows in 2015 are likely to be lower than in 2014, but Fitch expects restructuring measures to lead to a recovery of key metrics over the medium term.
1H15 results in the marine division were weak, where a low oil price has resulted in restrained investment from oil and gas companies and increased pricing pressure. The rest of the business had strong order coverage and significant services exposure, so we expect 2015 group revenues approximately flat on 2014. FFO adjusted net leverage could increase to around 1.5x from 1x in 2014 on somewhat weaker profitability. Cash flow is likely to see only a limited improvement over the coming two to three years as new programmes are launched and ramped up while production rates of the mature Trent 700 slow prior to the introduction of its replacement, the Trent 7000.
Gross Debt Increase
The October 2015 USD1.5bn bond issuance has increased our expectations of YE15 gross adjusted debt to GBP4.6bn from GBP3.7bn at YE14. This bond issuance provides additional liquidity over the upcoming cash absorption period but stresses our expectations of FFO gross adjusted leverage at YE15 to around 2.7x from 2.0x at YE14. This is beyond out negative rating guideline of 2x until cash generation builds after the investment period. We do not consider this to be a sustained part of the company's financial profile, and net leverage remains in line with our expectations for the rating level.
Resilient Business Profile
Rolls-Royce has demonstrated the ability to manage a broad portfolio of turbine-related assets and generate cash for several years despite industry challenges and wider economic pressures. The company is well placed to withstand potential declines in demand resulting from deteriorating market conditions, due to its business diversification, growing proportion of long-term service contracts, and cost-cutting measures.
Share Buyback Cancellation Supportive
The suspension of the GBP1bn share buyback programme at only GBP500m provides some additional headroom to maintain the company's financial metrics as it enters a period of cash absorbing programme launches and growth. In particular, the savings helps fund some of the lost earnings resulting from reductions in Trent 700 build rates over the next three years. The buyback was funded from the proceeds from the GBP985m sale of the energy gas turbine and compressor business to Siemens AG in December 2014.
Commercial Aerospace Outlook Positive
Rolls-Royce derives about half its turnover from the commercial aerospace industry, where the outlook for engine deliveries and service work remains positive. The production of large commercial aircraft - and the engines the company manufactures for them - is set to increase in the short to medium term, reflecting the strength and quality of the order book.
Fitch's key assumptions within the rating case for Rolls-Royce include the following.
- Approximately flat revenue in 2015 followed by low-to-mid-single-digit annual growth thereafter.
- A slightly reduced FFO margin in 2015 due to marine weakness, low profitability on deliveries of newly launched programmes. Cost reductions to offset further pressure on earnings from ramp up of new programmes over the coming 2-3 years.
- Capex to fall to around 7% of revenue due to lower development work in the pipeline.
- No changes to dividend policy.
- Share buyback to cease at GBP500m.
Future developments that may, individually or collectively, lead to negative rating action include the following.
- Lease-adjusted debt/FFO ratio of sustained higher than 2x (2014: 2.0x, 2015E: 2.7x).
- FFO/revenue ratio of less than 11% over a sustained period (2014:12.2%, 2015E: 10.9%).
- FCF margin consistently under 3% (2014: -2.6%, 2015E: -2.7%).
- Fixed charge cover of under 7x (2014: 7.8x, 2015E: 7.4x).
An upgrade is unlikely in the absence of a material change to the group's business profile, given that the company has reached a rating close to the highest Fitch deems achievable for the aerospace and defence industry.
Rolls-Royce had committed long-term banking facilities totalling GBP1.5bn and GBP587m of cash and short-term deposits at end-1H14 (net of a GBP1bn adjustment for intra-year operational cash requirements). A USD1.5bn bond was issued in October 2015. This compares to short-term borrowings of GBP267m. Rolls-Royce has a back-ended debt maturity profile and has good access to the capital markets.