The group is one of the world's largest civil aero-engine providers and also manufactures equipment for the defense, marine, and energy sectors. Civil aviation contracts account for more than 80% of the group's sizable order book of about GBP60 billion ($94 billion). Despite this concentration, the contracts are globally well-balanced, with a large proportion coming from fast-growing regions like the Middle East and Asia.
Rolls-Royce's business portfolio benefits from its participation in important defense programs and the growth potential of its marine business. In our opinion, the group's business risk is constrained by the cyclical nature of some of its markets, such as civil aerospace, as well as budgetary pressures that we anticipate will continue to constrain near-term performance of defense contractors. We consider these risks to be offset by the group's strong market position for new wide-body (or twin-aisle aircraft) programs and the relatively young age of its engine fleet, which reduces the risk of Rolls-Royce-powered aircraft being grounded or retired in a downturn. A further offsetting factor is the group's sales of aftermarket services, accounting for more than 50% of total revenues in 2011.
In the course of 2011, Rolls-Royce joined the Engine Holding GmbH (not rated) venture set up by "here &sid=977693&sind=A&" (A-/Stable/A-2). Engine Holding is in the process of acquiring Tognum AG, a German engine and drive system manufacturer, which Rolls-Royce's management expects to complete in the first half of 2013. In our view, the execution risks related to Tognum's integration and Daimler's option to sell its shares in the joint venture to Rolls-Royce could constrain the ratings on Rolls-Royce in the future if they materialize.
In October 2011, Rolls-Royce announced the restructuring of its participation in the International Aero Engines (IAE) partnership. As part of the restructuring, the group received a $1.5 billion cash inflow subject to further working capital adjustments. Although management has not indicated a particular planned use for these proceeds, we believe that it is unlikely that Rolls-Royce will use this cash solely to reduce leverage. If Rolls-Royce were to use this amount mostly to reward its shareholders, this would put pressure on the group's credit metrics.
S&P base-case operating scenario
We estimate that Rolls-Royce's earnings will increase at a low-double-digit annual rate over the next two to three years (excluding the contribution of Engine Holdings and IAE restructuring), based on our expectation of positive trends in most of the group's end markets and its leaner cost base following an extensive restructuring in previous years. We anticipate that the group will maintain an operating margin of about 11% in 2012 before financing costs and taxes, in line with past levels. This should generate sufficient funds from operations (FFO) to cover the extensive capital investments necessary to support Rolls-Royce's technology and manufacturing advantage. We therefore believe that Rolls-Royce will be able to maintain FFO to debt at levels above the 50%-60% range that we consider to be commensurate with the rating. S&P base-case cash flow and capital-structure scenario We anticipate that Rolls-Royce will be increasing its spending on research and development and capital expenditures in line with public guidance. As such, we expect it will generate neutral Standard & Poor's-adjusted free operating cash flow (FOCF) in the next 24 months. The proceeds from the sale of Rolls-Royce's equity stake in IAE should mitigate the impact on discretionary cash flow in 2012 and, possibly, 2013. Against the back-drop of steady earnings, we believe that Rolls-Royce will progressively increase shareholder remuneration in the medium term.
In the 12 months to June 30, 2012, Rolls-Royce posted FFO of GBP1.2 billion and marginally negative fully adjusted FOCF. Fully adjusted debt totaled GBP440 million.
The 'A-1' short-term rating reflects our view of Rolls-Royce's "strong" liquidity position as defined by our criteria. We consider the group's liquidity profile to be adequately supported by its ample available liquidity sources and its proactive treasury management. Our base-case liquidity assessment reflects the following factors and assumptions:
-- The group's sources of liquidity will exceed uses by at least 1.5x over the next three years. Sources include operating cash flow (FFO), surplus cash balances, and availability under the committed revolving credit facilities (RCF). Uses are mainly capital spending and possible acquisitions.
-- Liquidity sources would continue to exceed uses if EBITDA declined by 30%;
-- Rolls-Royce appears to have good relationships with its lenders; and
-- We understand that the group was in compliance with the interest coverage financial covenant included in the RCF documentation as of June 30, 2012, and had significant headroom. On June 30, 2012, liquidity sources consisted of surplus cash and cash equivalents of about GBP1.6 billion, excluding the GBP550 million that we consider tied to operations. This amount takes into account the $1.5 billion (GBP953 million) cash inflow from Rolls-Royce's sale of its equity stake in IAE, which the group received in the first half of 2012. In addition, Rolls-Royce has access to the GBP1.0 billion RCF maturing in 2017 and fully undrawn at the reported date.
Rolls-Royce does not have any near-term debt maturities, and the next sizable debt repayment is due in 2019, when a GBP500 million bond matures. The group's credit facilities do not include rating triggers that would require Rolls-Royce to accelerate or repay any of its borrowings. We also understand that Rolls-Royce is not at risk from liquidity triggers or margin calls with respect to the derivatives used in its hedge portfolio.
The stable outlook reflects our view that Rolls-Royce will continue to generate solid operating cash flow on the back of steady operating margins, and maintain a "modest" financial risk profile characterized by an average ratio of FFO to net debt of about 50%-60% throughout the economic cycle.
Therefore, Rolls-Royce's currently very solid credit metrics incorporate a fair degree of headroom. A rapid decline in FFO to debt to the low end of the 50%-60% range or lower (for instance, on the back of a significant increase in payments to shareholders or large debt-funded acquisitions) would signal a comparatively more aggressive financial policy and would put downward pressure on the ratings. Although unlikely for the next two years, we could raise the ratings if Rolls-Royce were to achieve a structural improvement in its earnings and cash flow generation, allowing it to consistently post operating margins in the mid-teens.
Related Criteria And Research
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"here 5045287&rev_id=11&sid=977693&sind=A&", June 24, 2009
"here 5426464&rev_id=13&sid=977693&sind=A&", May 27, 2009 [updated in Sept. 2012]
"here 5446217&rev_id=3&sid=977693&sind=A&", April 15, 2008