Rolls-Royce — Update 16 February 2017

Rolls-Royce — Update 16 February 2017

Rolls-Royce

Andy Chambers

Written by

Andy Chambers

Director, Industrials

Rolls-Royce Holdings

Emerging from the clouds

Aerospace & defence

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16 February 2017

Price

704p

Market cap

£12.9bn

Share price graph

Share details

Code

RR.

Listing

LSE

Shares in issue

1.838m

Business description

Rolls-Royce designs, develops, manufactures and services power systems for air, land and sea use. It is one of the world’s leading aero engines suppliers for large civil aircraft and business jets, and second in military engines and services. It also operates in diesel engines, marine and nuclear power markets.

Bull

Civil aero is in a growth phase that should generate substantial long-term positive cash flow once the current investment phase is completed.

Defence, Nuclear and Power Systems providing a relatively stable stream of earnings and cash flows.

Long-term aftermarket annuities provide substantial visibility for cash flows.

Bear

IFRS 15 application will mechanically reduce sales and profits on long-term contracts, but with no impact on cash flow.

Offshore marine markets remain extremely depressed.

Continuing fallout from bribery and corruption investigation settlement, including huge headline loss and switch of focus to former employees.

Analysts

Andy Chambers

+44 (0)20 3681 2525

Ali West

+44 (0)20 3077 5700

Rolls-Royce’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.

Scope for estimates to improve during FY17

As was seen in FY16, the new management team has adopted an under-promise and over-deliver philosophy. With FY16 numbers close to FY17 consensus expectations, the guidance for only modest growth is unsurprising at this stage. Assuming no dramatic economic shocks, we believe risk is currently to the upside. The adoption of IFRS 15 accounting next year will reduce sales and earnings estimates, but not affect cash expectations. Already stretched near-term multiples will thus be further strained, putting even greater emphasis on the development of medium-term margins and cash generation to support valuation.

Consensus estimates

Year
end

Revenue
(£m)

PBT
(£m)

EPS
(p)

DPS
(p)

P/E
(x)

Yield
(%)

12/15

13,354

1,432

58.7

16.4

12.0

2.3

12/16

13,783

813

30.1

11.7

23.4

1.7

12/17e

14,102

769

26.9

12.4

26.2

1.8

12/18e

14,704

862

32.8

14.8

21.5

2.1

Source: Bloomberg consensus estimates

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Frankfurt +49 (0)69 78 8076 960

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Germany

London +44 (0)20 3077 5700

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United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

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US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Disclaimer

Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt and Sydney. Edison is authorised and regulated by the Financial Conduct Authority. Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison and is not regulated by the Australian Securities and Investment Commission. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

DISCLAIMER
The research analyst primarily responsible for the preparation of this report personally holds an equity position in the company of less than 1%.

Copyright 2017 Edison Investment Research Limited. All rights reserved. This report has been prepared and issued by Edison for publication globally. All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison's solicitation to effect, or attempt to effect, any transaction in a security. The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are "wholesale clients" for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Edison has a restrictive policy relating to personal dealing. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report. Edison or its affiliates may perform services or solicit business from any of the companies mentioned in this report. The value of securities mentioned in this report can fall as well as rise and are subject to large and sudden swings. In addition it may be difficult or not possible to buy, sell or obtain accurate information about the value of securities mentioned in this report. Past performance is not necessarily a guide to future performance. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a "personalised service" and, to the extent that it contains any financial advice, is intended only as a "class service" provided by Edison within the meaning of the FAA (ie without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision. To the maximum extent permitted by law, Edison, its affiliates and contractors, and their respective directors, officers and employees will not be liable for any loss or damage arising as a result of reliance being placed on any of the information contained in this report and do not guarantee the returns on investments in the products discussed in this publication. FTSE International Limited ("FTSE") (c) FTSE [2017]. "FTSE(r)" is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE's express written consent.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Research: Consumer

Rank Group — Update 16 February 2017

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