Rolls-Royce improves guidance but takes £554m Trent hit

A leaner and meaner Rolls-Royce said full year profits and cash flow should be towards the higher end of expectations but that it had taken a £554m exceptional charge due to problems with its Trent 1000 aeroplane engine.

A strong first half for its civil aerospace and power systems businesses led to underlying profits swinging back into the black, with a core £146m operating profit and 3.1p earnings per share, as core revenues grew 16% to £6.68bn in the first six months of the year.

Chief executive Warren East said progress had been made with plans to simplify the group into three business units after selling its fuel injection and commercial marine businesses. Along with the civil aerospace arm, an enlarged defence business now includes naval, submarine and defence aerospace businesses, with the third being Germany-based power systems that now includes the civil nuclear unit. For the first half, civil aerospace revenues rose 26%, power systems by 13% while defence was pretty much flat.

The restructuring, which will mean the axing of 4,600 jobs, comes with a target to achieve annual run-rate savings of £400m by the end of 2020.

East said he remained confident in this target and in the general performance this year that led him to expect both underlying profit and cash flow for 2018 will be "in the upper half of our guidance range". So for the core business, management expect 2018 underlying operating profit and free cash flow of £450m and £400m respectively, plus or minus £100m. Operating profit had previously been guided to a range of £300-500m.

On the downside he said the challenge of managing "significant" issues with the Trent 1000 engine for airline customers had led to taking the exceptional charge of £554m, which represents the profit impact of that part of the total current and estimated costs out to 2022 that is considered to be abnormal, out of the estimated full £1bn to rectify problems with the engines.

For the full calendar year, East estimates the cash costs for Trent 1000 and Trent 900 in-service issues will be approximately £450m, as flagged in June, with a combined cash cost for 2019 now expected to be at a similar level to 2018, before declining by at least £100m in 2020. Despite this, he said 2019 underlying free cash flow is expected to improve on 2018.

At the statutory level, operating losses widened to £775m from £103m a year ago, while a total reported loss before tax of £1.26bn was a significant decrease compared to the £1.44bn profit in same period last year, due to factors including a big swing in currency effects, restructuring charges of £179m and a £358m gain from selling L'Orange this June.

An improvement in free cash flow of £211m versus the prior year's outflow of £339m was driven by defence and a reduced outflow in civil aerospace, helping, along with the disposal of L'Orange, a swing to a net cash position of £165m from debt of £305ma year ago.

Rolls-Royce shares rose on Thursday morning, topping £10 for the first time since 2015.

Analyst George Salmon at broker Hargreaves Lansdown said that despite the £775m reported loss and £1bn cost to rectify the Trent 1000 engines, "there’s reason to think Rolls is starting to find the next gear" with the three core divisions all showing signs of improvement.

"It’s particularly good to see civil aerospace output rise. It may not be generating any profit yet, but the division is clearly moving in the right direction, meaning Rolls’ ambition to become the world leader in engines for large aircraft is starting to look within reach. The challenge will be managing the disruption caused by failures in its Trent line, while avoiding any more mishaps when rolling out the recently unveiled Pearl range," Salmon said.

"The 2020 target of delivering over £1bn in free cash flow might feel some way off at the moment, but if Rolls can keep streamlining its complex operations and keep recent momentum going, there’s no reason it can’t get there. Meeting that goal would help get the engines roaring on the dividend again.”

Artjom Hastaturjants at Accendo Markets noted that revenue guidance for power systems has been upgraded from high single-digits to low double-digit growth and that EBITDA margins in the more important defence sector are not expected to fall as much as first though, down 150bps versus 250bp previously.

"Both may not be enough to deliver an upgrade in guidance per se, but they are perhaps hinting at the potential for a mild beat, come FY results, even after all those engine woes," he said.