RLLCF - Rolls-Royce: Better To Invest Your Money Elsewhere

Summary

• Revenues and profits that do not show sufficient continuity for this company to outperform the market in the long run.
• There are currently better opportunities in the market than a heavily indebted company with negative equity due to continued losses in the income statement.
• Total debt keeps increasing, liquidity keeps decreasing.

Rolls-Royce Holdings ( RYCEY ) operates internationally as an industrial technology company, offering primarily aircraft and marine engines. The brand name of this company is associated worldwide with well-known luxury cars; however, Rolls-Royce Holdings sold the license related to the automotive division to BMW some time ago. To date, the company seems quite distressed, and the market cap halved compared to the beginning of the year is an indication that the market is concerned about its future performance. In this article, we will see what the main problems are and why I do not believe in this company in the long run.

Troubled profitability

Reflections on the past 10 years

As a first aspect, we will evaluate long-term profitability. A solid company with a competitive advantage should show growth over the long term, but this is not the case with Rolls-Royce.

Current revenues and profits are lower than they were 10 years ago, which is quite worrying. Even assuming that the current troubles are caused by the difficult macroeconomic environment, it should be noted how Rolls-Royce was struggling to generate profits even before the pandemic broke out. It is very common for this company to incur losses considered "extraordinary" in the range of billions of pounds. This was not an optimal situation before, and to date, things have only gotten worse. From a long-term perspective, Rolls-Royce has proven in the past that it is not a good investment. Certainly, there have been opportunities for short-term gains being a very volatile stock, but for those presenting a buy-and-hold strategy, I don't think they are happy with the results achieved so far.

H1 2022

Focusing on the first half of this year, the situation seems more complicated than in the past. To add to the usual supply chain issues, inflation, and rising interest rates, Rolls-Royce is also subject to the significant depreciation that the pound has had against the dollar.

Such a depreciation has not been seen since 1985, and it is impacting this company's balance sheet. Exports are more advantageous, but on the other hand, imports are more disadvantageous. In addition, such marked exchange rate fluctuations can create significant risks related to the depreciation of derivatives on the balance sheet assets.

Based on the H1 2022 results , we can see that revenues increased by £441 million compared to H1 2021, benefiting from a weak pound. As a result, gross profit and operating profit also achieved an increase. Up to this point the devaluation of the pound has had an overall positive effect, but under the next item "Net financing costs/income" a loss of just over £2 billion has been found. What is this all about?

£1.53 billion is attributable to net fair value losses on foreign currency contracts, thus a write-down of derivative contracts on the balance sheet, while £464 million is attributable to net foreign exchange losses. Since net fair value losses are a non-cash expense, the £1.53 billion loss did not adversely affect the cash flow statement. In fact, in H1 2022 Rolls-Royce generated a positive cash flow from operations of £597 million despite a large loss in the income statement. Since this balance sheet represents only the first part of the year and the pound continued to depreciate greatly even in this second part, I expect that in H2 2022 a similar situation will arise again.

How did individual segments perform in H1 2022

Civil Aerospace is the most important segment for the company in terms of revenue and has presented organic growth of 8% over H1 2021, however, it still remains at a loss as it has not yet fully recovered from the consequences of the pandemic. Here is the company's guidance on this segment:

• Engine flight hours will maintain current trajectory and return to pre-pandemic levels in 2024 as global travel restrictions are lifted.
• In 2022, 350-400 total OE deliveries and 1,100-1,200 total shop visits are expected. Underlying revenue growth at a low double-digit percentage CAGR.
• Efforts will be made to keep costs low, supporting improved profitability in 2022 compared to 2021. Underlying operating profit margin expansion to a high-single-digit percentage.

The Defense segment is the second largest in terms of revenue and is the only one that has experienced negative organic growth since H1 2021. Although the operating margin has decreased, at least positive operating income is present, unlike the Civil Aerospace segment. According to the company, this segment is not immediately exposed to short-term changes in defense demand, but the increase in military spending in this 2022 has strengthened the long-term outlook. In this segment, Rolls-Royce is investing heavily in decarbonization and modernization of its facilities. A low double-digit operating margin in 2022 is expected.

The Power systems segment is the least important in terms of revenue, but at the same time, it is the fastest growing. With 20% organic growth over H1 2021 and an operating margin up 5.2 percentage points, it is by far the best-performing segment. Demand for products in this segment remains high, but the problem is that supply chain-related slowdowns are not allowing Rolls-Royce to produce as much as desired. The company predicts that this issue will impact the entire 2022.

Overall, from a growth standpoint, this first half of 2022 saw the Power Systems segment outperform the others. No profit was recorded due to the loss in fair value of derivative contracts, but cash from operations remains positive. Compared to pre-Covid years, profitability still appears limited and discontinuity remains higher than in the past. In the next section, we will see what this discontinuity entailed from a financial/equity perspective and how debt sustainability has changed compared to a few years ago.

Too much debt

The high debt of this company is the main reason for me not to invest in it. While I prefer companies with low debt, I do not find it wrong to invest in indebted companies if the income supports that debt. The problem with Rolls-Royce is that the debt is so high because of two underwhelming years due to the pandemic, and it lacks solid income to deal with it. This does not mean that the company will go bankrupt tomorrow, but that in order to be able to bring down the current level of debt, Rolls-Royce will struggle as it is not supported by steady and growing revenues and profits. Historically, we have seen how profits are up and down, and the current macroeconomic environment certainly does not help. I will now show you some charts to support my thesis.

Total debt is increasing every year, but what is really worrying is that net debt is increasing even faster. Before the pandemic, it was £1.22 billion, today $5.34 billion: a 335% increase. This implies that the company's liquidity is decreasing more and more, while the total debt follows the opposite trend. In addition, we can see how the company's equity has now sunk below 0 due to the continuous losses on the income statement that began well before the pandemic. This is certainly not an optimal situation for shareholders, even considering that such negative equity does not come from a strong buyback plan.

Debt sustainability is at great risk:

• It takes nearly 10 years of FFO to cover total debt, in 2018 just over 2.
• Net debt is 4.13 times larger than EBITDA, a worrisome figure given that in 2018 it was almost half.

Overall, this is a rather worrisome balance sheet situation since Rolls-Royce is severely undercapitalized. Covid has completely distorted its balance sheet.

Previously, the company was also able to issue a sustainable dividend, which as of today is a utopia. With severely negative equity and huge debt, the worst thing to do would be to issue a dividend and reduce equity even more.

At this point, some of you may be wondering, how long can this company remain liquid if it has such a large debt and continues to make losses? In its latest report, Rolls-Royce answered this doubt.

As of June 2022, the company held total liquidity of £7.3 billion, including:

• £2.8 billion of cash and cash equivalents.
• £4.5 billion of undrawn facilities. The company considers this amount of money as liquid because being "committed," the lender is obligated to lend money to the borrower when requested. So, if Rolls-Royce ever needs it, it will have £4.5 billion to borrow. Beware, however, of the maturities of these contracts (included in the image) and the increase in debt.

Considering the total liquidity of £7.3 billion, combined with estimated future cash flows, the company stated that it has sufficient liquidity for at least the next 18 months. It is therefore highly unlikely that in the short-term Rolls-Royce will be illiquid, but doubts about the long term remain.

In conclusion, in light of all the considerations made, my rating is a strong sell. I do not see how in the long run this company can outperform the market:

• Low operating margins, revenues that have stalled for years, and profits that are too discontinuous.
• Negative equity, high net debt, no dividend, and adverse macroeconomic environment.

In addition, after the recent collapse of the S&P 500 interesting buying opportunities have arisen for solid companies that were previously overpriced, one more reason to invest money elsewhere. Essentially, I see no reason to speculate on Rolls-Royce when you can buy companies like Alphabet and T. Rowe Price at a discount. In any case, nothing is certain about the future and I could be wrong.

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