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
&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
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
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
-- 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
-- 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
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
All articles listed below are available on RatingsDirect on the Global Credit
Portal, unless otherwise stated.
5045287&rev_id=11&sid=977693&sind=A&", June 24, 2009
5426464&rev_id=13&sid=977693&sind=A&", May 27, 2009 [updated in Sept. 2012]
5446217&rev_id=3&sid=977693&sind=A&", April 15, 2008