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Rating Action:

Moody's changes the outlook on Rolls-Royce's ratings to negative; affirms A3 ratings

22 Feb 2017

Frankfurt am Main, February 22, 2017 -- Moody's Investors Service, ("Moody's") has today changed the outlook on Rolls-Royce plc's rating (Rolls-Royce) to negative from stable. Concurrently, Moody's has affirmed the A3 senior unsecured instrument ratings and (P)A3 senior unsecured MTN rating.

"Our decision to change the outlook on Rolls-Royce's A3 rating to negative from stable reflects our view that the company will continue to generate weak cash flows through 2018 and that continuing headwinds in most of Rolls Royce's segments and risks associated with the company's material ramp up plans in 2017 may delay stronger and more meaningful positive cash flow generation by 2019." says Jeanine Arnold, a Moody's Vice President - Senior Analyst and lead analyst for Rolls-Royce.

RATINGS RATIONALE

Moody's rating action follows our expectations that key credit metrics, including free cash flow (FCF) generation and gross adjusted leverage, will remain weak in the context of the company's A3 rating through 2018 and that a number of headwinds in most of Rolls Royce's segments may prevent a sufficient improvement in these credit metrics over the medium-term. In 2016 Debt to EBITDA continued to be high at 2.8x while FCF (based on Moody's calculations) was negative at around GBP175 million. We expect FCF generation in the region of GBP800 million which is expected to be achieved by 2019 to be more commensurate with the rating level.

The ability for Rolls-Royce to achieve this is dependent on recovery in the company's non-aerospace divisions, especially in marine, but, more importantly, success in the material ramp up of its larger engines during 2017. In 2017 Rolls-Royce expects to increase production to more than 500 large engines in 2017 from 357 in 2016 -- largely driven by the Trent XWB engine program for the A350. The increase in delivery of new engines will continue to weigh on the company's profitability but most importantly cash flows, as new business in generally sold at low or even negative margins. Only the related service contracts will lead to more steady cash flows from incremental service revenues, but only by 2018/19.

However, we believe there are some risks that do not fully guarantee this FCF generation, including but not limited to:

i) Execution and supply chain risks. This may delay the entry into service of new engines (Trent XWB-97, Trent 1000 TEN and the Trent 7000) and the material ramp up of the Trent XWB engine as well as lead to unexpected costs. While this would initially delay the cash losses associated with the new engines sold, it would also postpone higher margin and more steady cash flow generation from service revenues associated with these engines;

ii) Less favourable market conditions for wide-body aircraft. With the material ramp up of the Trent XWB, Rolls-Royce is increasingly exposed to wide-body aircraft, which relative to narrow-bodies tend to be more exposed to economic shocks. This would likely constrain volumes of new engine sales, but more importantly lower future flying hours across the company's portfolio including its more mature programs.

Nevertheless, the A3 rating continues to take into consideration the company's strong business profile supported by a strong order backlog, accounting for more than 5x of 2016 turnover; high barriers to entry given the critical technological content of the company's engines; the still supportive market environment for Aerospace and Defence owing to still strong passenger numbers and the company's evidenced commitment to maintaining a conservative financial profile, as evidenced by the recent reduction in shareholder payments, and strong liquidity.

Outlook

The negative outlook reflects our expectations that FCF will remain weak, or even negative through 2018 and there are risks associated with the company's ability to improve FCF to around GBP800 million by 2019, and support more rating-commensurate credit metrics

Factors that Could Lead to an Upgrade

Although not expected over the immediate rating horizon, upward rating momentum could occur if the following is on evidence:

» Strong growth in top line accompanied with improved profitability, owing to improved conditions and performance in the marine and business jet markets

» Maintenance of an excess liquidity buffer while financial leverage trends towards 1.5x

» Earlier than expected transition to robust free cash flow profile

» Interest coverage (EBIT-to-Interest) > 10x and operating profit margins > 10%

Factors that Could Lead to a Downgrade

» Financial leverage that remains elevated

» Longer transition period with a cash absorptive operating profile such that we do not expect free cash flow (after dividends) to become solidly positive in 2018 and accelerate thereafter.

» More aggressive shareholder return initiatives and financial policies

The company has indicated that it expects to make substantial adjustments to certain metrics as a result of upcoming transition to IFRS 15, so we may refine our guidance once the company has implemented IFRS 15 adjustments and updated its own projections accordingly. Our rating guidance will continue to give credit for the benefits and stability of the long-term contracts which potentially deliver profitability over a multi-year horizon; but equally, to maintain the current A3 rating it is necessary for the company to continue to leverage its enviable market position to generate ongoing profitability and positive cash flow.

Liquidity

Cash on balance sheet was GBP2.8 billion (2015: GBP3.2 billion) which combined with GBP2.3 billion of undrawn facilities provides sufficient liquidity to cover the company's GBP3.4 billion of funded debt (c.GBP3 billion including c. GBP358 million fair value of swaps). Liquidity was further supplemented with a GBP500 million increase in revolving credit facilities (2019 maturity), with the maturity for the existing GBP1.5 billion revolver extended to 2021 (both unrated). Near-term debt maturities are relatively modest, with next major maturity coming in April 2019 (GBP500 million of bonds). We expect Rolls-Royce to draw an existing EIB loan in 2017, but repay other outstanding debt in 2017 through cash reserves.

We believe the company's high cash levels are important given the upcoming ramp and our expectations that working capital movements will vary significantly throughout the year. Year-end cash balances tend to be the high point of Rolls-Royce's seasonal cycle, with aircraft deliveries and receipts from government contracts skewing towards the end of the fourth calendar quarter.

The principal methodology used in these ratings was Global Aerospace and Defense Industry published in April 2014. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Jeanine Arnold
Vice President - Senior Analyst
Corporate Finance Group
Moody's Deutschland GmbH
An der Welle 5
Frankfurt am Main 60322
Germany
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Matthias Hellstern
MD - Corporate Finance
Corporate Finance Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Deutschland GmbH
An der Welle 5
Frankfurt am Main 60322
Germany
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

No Related Data.
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