Rolls-Royce Holdings PLC (LSE:RR.) was termed a ‘broken business’ by analysts today, as its profit margins were squeezed amid an ever-lengthening trajectory to post-pandemic recovery.
Hopes for a second-half revival “could prove forlorn”, said analyst Danni Hewson at AJ Bell, and "given the inflationary pressures and impact from conflict in Ukraine, the incoming CEO may need to find a more dramatic fix for a now rather broken business.”
The engineer’s financial results for the first half showed contracted flight hours in its civil aerospace business had only recovered 60% from pre-pandemic levels thus far and are not expected to recover fully until 2024.
Hewson warned that macroeconomic factors that continue to plague the aerospace sector could further slow its post-pandemic recovery.
“Where we’re positioned in terms of the US and Bank of England predicting a recession and inflation peaking at 13%, that just suggests that the recovery for aerospace is unlikely to be where we need [or] the expectation even a couple of days ago,” Hewson told Proactive.
The civil aerospace business has been a real “cash cow” for Rolls-Royce, which has serviced engine agreements for plane manufacturers and airlines such as Boeing and Malaysian Airlines. Yet its traditionally core business is declining.
“For a good 10 years it was a real cash cow for them,” Hewson said of the long-term service agreements for its engines. “The more flying hours, the more wear and tear experienced, and the more spares and repairs [are needed].”
Civil aerospace accounted for about half of Rolls-Royce's business before the pandemic, falling to about 41% last year, Hewson said.
“[Civil aerospace has] taken a kicking,” she said. “They’re (Rolls-Royce) not expecting flying hours to get back to pre-pandemic levels until 2024.”
Where Rolls has succeeded is in servicing the agreements effectively over the lifetime of its engines, dotting the ‘i’s and crossing the ‘t’s. The issue is that LTSAs, while being cash generative for the company, do not allow for flying to be contracted or pre-agreed, meaning they took a hit when travel bans were enforced during Covid-19.
“Like any agreement, long-term service agreements come with risks and rewards for both parties,” Allegra Dawes, an equity analyst at Third Bridge, told Proactive.
“For Rolls-Royce, the primary risk is that LTSAs increase the company’s exposure to and dependence on engine flight hours. In a pre-Covid world where airlines are utilising fleets at a high level, this exposure is not problematic. In a pandemic impacted market it has become a significant liability.”
Civil aerospace could once again be a cash cow for Rolls-Royce but its recovery might be delayed due to macroeconomic headwinds, according to Hewson.
Dawes said the engineer’s recovery so far “has been anaemic” and that it has “begun to lose the faith of investors”, despite outgoing chief executive Warren East’s adamance that its recovery was still on track in the face of ‘disappointing’ interim results.
Covid-19 was a gamechanger with unprecedented disruption to flights and a challenge for the LTSA model, as flight hours cannot be forced in contracts; according to Dawes, Rolls-Royce “may struggle to protect [its] margin” in fixed-priced agreements.
“Nobody expected what happened from Covid,” Hewson said of how the pandemic impacted the travel and aviation sector.
“That figure [the number of flying hours] has just absolutely tanked...Getting back to where we were is going to be slow.”
Rolls-Royce will bring on board former BP executive Tufan Erginbilgic as its new chief executive in January next year, and there are high hopes that he will fix whatever is broken at the company given his track record of growth.
Experts at consultancy Third Bridge believe Rolls-Royce has made “significant improvements to its cost base” and “should eventually enable a return to a more normal level of profitability and cash generation”.
“The new CEO will have to convince investors that excuses for their slow recovery are over and that the company is taking meaningful steps to return to profitability,” Dawes said.
“There are some initial signs that Rolls-Royce can turn the corner, notably in the significant cash burn reduction.”
With his background in the energy sector, Erginbilgic may choose to focus on growth in the company’s marginal power systems business, which posted a record second quarter but accounts for about a quarter of annual revenue, or look to sell off the asset.
The company has split its business before, famously selling off car production rights to Volkswagen, which are now owned by BMW, and recently hiving off engine manufacturer IPT Aero.
“The new boss coming in might just want to continue going down [East’s] route, or may want to think about doing something more dramatic,” Hewson said. “We’ve heard a lot about companies that have got too big breaking off parts of the business. We know it’s sold some parts. [He] could consider hiving off the power part.”
Much depends on what opportunities the engineering behemoth pursues for expanding its nuclear reactor segment, and how nuclear energy policy is shaped in the coming months.
“Rolls are looking at creating mini nuclear reactors. That's technology which could be sent out right around the world. It potentially stands to make an awful lot of money,” Hewson said. “They might think [it is] an area with significant growth to be achieved.”