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Rating Action:

Moody's downgrades Rolls-Royce to Ba2 from Baa3; outlook negative

27 Jul 2020

London, 27 July 2020 -- Moody's Investors Service ("Moody's") has today downgraded the long-term senior unsecured rating of Rolls-Royce plc (Rolls-Royce or the company) to Ba2 from Baa3. Concurrently Moody's has assigned a corporate family rating of Ba2 and Ba2-PD probability of default rating to the company. The outlook remains negative. Today's rating action reflects:

• Moody's expectations of substantial cash outflows in 2020 and 2021 resulting in materially increased leverage, in excess of Moody's previous expectations

• Uncertainties over the timing and extent of recovery in flying hours and commercial aircraft deliveries due to the coronavirus pandemic with risks of further material cash absorption and an uncertain path to recover the company's balance sheet metrics

• Execution risks in the implementation of the company's substantial operational restructuring and cost-cutting programme

• Rolls-Royce's material liquidity, strategic importance and willingness to restore metrics

Concurrently, Moody's has downgraded the rating on the company's senior unsecured Euro Medium Term Notes (EMTN) programme to (P)Ba2 from (P)Baa3, and downgraded the notes issued under the EMTN programme to Ba2 from Baa3.

RATINGS RATIONALE

The company's Ba2 corporate family rating reflects: 1) high barriers to entry given the critical technological content of the company's engines; 2) the solid performance of the company's defence division and its diverse revenues across different end markets; 3) the strong to date performance of the company's Trent XWB and Trent 7000 engine programmes which represent the majority of future orders and installed engine base; 4) the strategic importance of the company to UK defence capabilities and to the aerospace supply chain, resulting in a high likelihood of government support if required as a result of the coronavirus outbreak; 5) the company's commitment to a conservative financial profile; and 6) significant levels of liquidity.

The rating also reflects: 1) an expected multi-year slowdown in new commercial aerospace and in commercial aftermarket revenues; 2) Moody's expectations for substantial free cash outflows in 2020 and 2021 and possibly beyond, leading to increases in leverage which the company faces challenges to recover over the next 2-3 years; 3) high uncertainties over the progression of the coronavirus pandemic which could lead to further material cash outflows; 4) execution risks in implementing a material restructuring programme whilst maintaining operational effectiveness and competitive position; 5) ongoing execution risks of rectifying problems relating to the Trent 1000 engine programme and risks to the company's reputation and position on future programmes if Trent 1000 fixes are further delayed; and 6) concentration risks with reliance on a small number of commercial aerospace engines for widebody aircraft.

The rapid and widening spread of the coronavirus outbreak, deteriorating global economic outlook, falling oil prices, and asset price declines are creating a severe and extensive credit shock across many sectors, regions and markets. The combined credit effects of these developments are unprecedented. The aerospace and defense industry will be affected by the deep capacity cuts and financial stress for passenger airlines, leading to very significant reductions in aftermarket activity and widespread deferrals of new commercial aircraft deliveries.

Rolls-Royce has been materially affected by the coronavirus pandemic as a result of reduced flying hours, which drive lower aftermarket revenues and cash flows, and lower demand for commercial aircraft. Moody's does not expect commercial passenger demand to recover to 2019 levels until 2023 at the earliest, and it is likely to remain severely constrained in 2021. New aircraft demand is likely to recover even slower than passenger demand, and there are substantial risks that Airbus SE (A2 Negative) and Boeing (The Boeing Company - Baa2 Negative) will need to cut production rates below current levels in response. Rolls-Royce is exposed to the widebody aircraft segment which is likely to recover more slowly than the market as a whole.

The company has incurred a free cash outflow of approximately GBP3 billion in the first half of 2020 and expects an outflow of GBP4 billion for the full year 2020, including around GBP1.1 billion outflow from the cessation of invoice discounting.

The underlying outflows are driven by lower flight hours, which have not been matched by an equivalent reduction in maintenance costs under the company's long-term aftermarket service agreements, leading to a significant working capital outflow. There has been a further material cash outflow in the current year as a result of a high working capital inflow at the end of 2019 associated with the timing of aircraft deliveries, which is unlikely to be repeated in 2020 or future years. Further contributing factors to the cash outflow are lower engine deliveries as well as restructuring and other exceptional costs. Moody's estimates that Rolls-Royce will incur a working capital outflow of around GBP2 billion in 2020 and does not expect this to reverse materially in subsequent periods.

Moody's expects further cash outflows to arise in 2021, and potentially in subsequent years, depending on the profile of demand recovery and the company's ability to deliver its restructuring and cost saving programme. Moody's notes the scale of the company's restructuring which is subject to execution risk both in the delivery of savings and also in the company's ability to sustain its operational performance and competitive position during this period of disruption. There are also execution risks remaining in completing the fixes of the company's Trent 1000 engine and delivering anticipated levels of durability and aftermarket profitability, although Moody's notes that Rolls-Royce has now eliminated grounded aircraft relating to Trent 1000 fixes and the company is making continued progress addressing the remaining component redesign.

As a result of higher that previously expected cash outflows, Moody's expects material increases in leverage, and considers that the company faces significant challenges to recover its metrics over the next two to three years. Moody's also factors into the ratings the willingness and intention of Rolls-Royce to strengthen its balance sheet.

Moody's regards the coronavirus outbreak as a social risk under its ESG framework, given the substantial implications for public health and safety.

Governance considerations that Moody's includes in its credit assessment of Rolls-Royce include: (1) the company is listed on the London Stock Exchange and reported that during 2019 it was compliant with the UK 2018 Corporate Governance Code, other than in relation to the appointment of the Chairman of the Remuneration Committee; and (2) Rolls-Royce's complex business model and financial reporting is a significant challenge in understanding financial performance, particularly in relation to profitability on long-term aftermarket contracts, quality of cash flows, and adjustments to normalised profits.

LIQUIDITY

Rolls-Royce continues to maintain significant levels of liquidity. As at 30 June 2020 the company's total pro forma liquidity amounted to GBP8.1 billion, comprising a gross cash balance of GBP4.2 billion, an undrawn revolving credit facility of GBP1.9 billion and pro forma for a new GBP2.0 billion five year term loan partially guaranteed by UK Export Finance.

Moody's considers that the company would be well placed to receive support from the UK Government (Aa2, Negative) if required as a result of the coronavirus pandemic, given the company's strategic importance to UK defence and engineering capabilities, and as a large employer directly and via its extensive supply chain. Given the company's significant liquidity such support is not currently expected to be required, however this cannot be discounted in view of uncertainties surrounding the duration and severity of the outbreak, alleviation actions by the company and potential working capital movements.

STRUCTURAL CONSIDERATIONS

The company's EMTN programme is rated (P) Ba2, and its senior unsecured notes issued under this programme are rated Ba2, in line with the corporate family rating. This reflects their pari passu ranking with the rest of the company's debt facilities.

OUTLOOK

The negative outlook reflects Moody's expectations that the commercial aerospace market will remain significantly reduced over the next 12-18 months and beyond. It also reflects the highly uncertain operating environment with risks to the pace of recovery in passenger demand, potential for further travel restrictions and execution risks in the implementation of the company's restructuring programme.

FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS

The ratings are unlikely to be upgraded in the short term. Positive rating pressure, including a stabilisation of the outlook, would not arise until the coronavirus outbreak is brought under control, travel restrictions are lifted, airline passenger traffic resumes and the market for commercial aircraft stabilises. At this point Moody's would evaluate the balance sheet and liquidity strength of the company and positive rating pressure would require evidence that the company is capable of substantially improving its financial metrics and liquidity headroom within around a 2-3 year time horizon. Quantitively an upgrade would require:

• Moody's-adjusted leverage to reduce towards 5x, and maintaining material cash on balance sheet

• Moody's-adjusted free cash flow to become materially positive

In addition positive rating pressure would require that the company resolves its Trent 1000 engine issues as anticipated in 2021, generates a track record of performance in line with guidance, and maintains a conservative financial policy.

The ratings could be downgraded if:

• the effects of the coronavirus outbreak increase in severity leading to liquidity concerns for which government support is not readily available

• there are clear expectations that the company will not be able to improve financial metrics to a level compatible with a Ba2 rating following the coronavirus outbreak, in particular if:

- Moody's-adjusted debt / EBITDA is not reduced sustainably below 6x, especially if not sufficiently balanced by cash on balance sheet

- Moody's-adjusted FCF / debt does not turn positive

- EBIT / interest cover is sustained materially below 2x

• there are signs of a weaker business profile, including a weakening in the company's market positions, or lower than expected aftermarket profitability, including as a result of further challenges in remediating Trent 1000 issues

• the company adopts more aggressive shareholder return initiatives and financial policies

PRINCIPAL METHODOLOGY

The principal methodology used in these ratings was Aerospace and Defense Methodology published in July 2020 and available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1224306. Alternatively, please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

COMPANY PROFILE

Headquartered in London, England, Rolls-Royce is a leading global manufacturer of aero-engines, gas turbines and reciprocating engines with operations in three principal business segments -- Civil Aerospace, Defence and Power Systems. In 2019 the company reported revenue of GBP16.6 billion and Moody's-adjusted EBITDA of GBP1.45 billion.

REGULATORY DISCLOSURES

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security 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.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

These ratings are solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website www.moodys.com.

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

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1133569.

At least one ESG consideration was material to the credit rating action(s) announced and described above.

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.

Martin Robert Hallmark
Senior Vice President
Corporate Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Richard Etheridge
Associate Managing Director
Corporate Finance Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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