Rolls-Royce Holdings PLC – Seeking recapitalization amid historic aerospace downturn.

Rolls-Royce Holdings PLC (LON: RR.) is a FTSE 100 listed Industrial Technology Company, which caters to the planet’s power needs. It has over 400 airlines customers, 5,000 power and nuclear customers in more than 150 countries.

Investment Rationale – Sell at GBX 195.00

• From a trading multiple perspective (EV/EBITDA, EV/Sales, and Price/Cash Flow), stock seems overvalued as compared to Aerospace and Defense industry.
• The Company’s Gross Margin, EBITDA Margin and Net Margin are in negative territory, whereas the industry has been delivering positive fundamentals.
• The stock is trading close to a 52-week high while 200-Day SMA (209.51) giving the downtrend signal, a short-term correction in price can be expected.
• The stock has given a negative return of ~75.36% in the last one year, whereas FTSE 100 has taken a hit of ~17.16%.

Risk Assessment

• The Covid-19 pandemic can have an adverse effect on RR’s business operations as it can lead to delay in contracts, reduced spending by the major defense and commercial customers, cancellation of obtained contracts, and lack of funding availability.
• The overall business of the Company could also be affected by a change in regulations and government policies.
• The Company is exposed to several market risks, some of which are of a macro-economic in nature such as, fluctuations in foreign currencies, oil prices, and interest rates.

Recent News:

5 October 2020: Post announcing its recapitalization package on 1 October 2020 (wherein the Company announced nearly £2 billion of fully underwritten rights issue), RR intends to raise £1 billion in gross proceeds through bond offering to enhance its financial resilience.

Half-Year Results for the period ended 30 June 2020 (as on 27 August 2020)

 (Source: Company Website)

• The Covid-19 pandemic has given an unprecedented impact on the civil aviation sector, and thus, it has significantly impacted the financial performance in FY20.
• Therefore, the Company has adopted capital restructuring decisions and several cost-cutting measures.
• The potential disposal of ITP Aero and other assets is expected to generate over £2 billion in gross proceeds.
• As of 30 June 2020, the liquidity stood at £6.1 billion, which comprised of £4.2 billion of cash, £1.9 billion of undrawn revolving credit facility, and additional £2.0 billion under undrawn term loan (finalised in August 2020).

One Year Share Price Chart

 (Source: Refinitiv, chart created by Kalkine Group)

Valuation Methodology: EV/Sales Approach (NTM) (Illustrative)

Conclusion

Although the Company started FY20 with positive momentum, the Covid-19 pandemic severely impacted the performance in H1 FY20 and medium-term projections. The most pronounced hit was observed in Civil Aerospace segment though Power Systems was relatively less impacted. Adjacently, Defence segment remained resilient without much material impact; however, industrial markets were suppressed. Similarly, ITP Aero was affected as severely as Civil Aerospace.

With cost-reduction measures, RR is expecting to generate the cash flow benefit of over £1 billion in FY20. Notwithstanding, the Company did not recommend a final dividend payment of 7.1 pence per share and did not approve an interim shareholder payment for H1 FY20.

Regarding outlook, it expects a gradual recovery in civil aviation activity towards the end of H2 FY20. However, most Power Systems end markets are expected to recover by the end of FY21, and revenues are likely to be back in FY22 to FY19 level. Despite uncertainties, defence performance is likely to remain resilient. Furthermore, it expects large engine deliveries to gradually increase beyond FY22, albeit it shall remain below FY19 levels until the FY25.

In respect to guidance, FY20’s underlying revenue is projected to be 25-30% lower than FY19. However, it is targeting a positive cash flow during H2 FY21, and by FY22, the Company should return to an annual free cash flow of £750 million. Stock 52 week High and Low were GBX 792.00 and GBX 100.80, respectively.

Given the heightened level of uncertainties, we recommend a “Sell” stance on Rolls-Royce Holdings PLC at the current price of GBX 195.00 (as on 13 October 2020, before the market close at 8:00 AM GMT+1), while we look forward to reviewing the upcoming catalysts and reinvest at the right price for value investing.  

*All forecasted data and peers information have been taken from Refinitiv, Thomson Reuters.

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