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Rating Action:

Moody's downgrades Rolls-Royce to Ba3 from Ba2; outlook remains negative

25 Sep 2020

London, 25 September 2020 -- Moody's Investors Service ("Moody's") has today downgraded the corporate family rating (CFR) of Rolls-Royce plc (Rolls-Royce or the company) to Ba3 from Ba2. Concurrently Moody's has downgraded the company's long-term senior unsecured rating to Ba3 from Ba2. The outlook remains negative.

Today's rating action reflects:

• A worsening outlook for recovery of flight hours and deliveries in the company's large commercial engine division over the remainder of 2020 and in 2021

• Expectations for cash outflows in 2020 and 2021 at the higher end of Moody's estimates, which could put pressure on liquidity and balance sheet metrics in the absence of further finance raising

• Whilst the company is evaluating potential equity and debt issuance, which would be credit positive, concerns that this would not be sufficient to maintain a balance sheet commensurate with a Ba2 rating

Moody's has also downgraded the rating on the company's senior unsecured Euro Medium Term Notes (EMTN) programme to (P)Ba3 from (P)Ba2, downgraded the notes issued under the EMTN programme to Ba3 from Ba2, and downgraded the company's probability of default rating to Ba3-PD from Ba2-PD.

RATINGS RATIONALE

The company's Ba3 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; and 5) the company's commitment to a conservative financial profile.

The rating also reflects: 1) a weakening environment for commercial aerospace in view of a slow recovery of engine flight hours pressured by travel restrictions, quarantine measures and broader coronavirus outbreaks across several regions; 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 in concluding fixes relating to the Trent 1000 engine programme; and 6) a degree of concentration risk with reliance on a small number of commercial aerospace engines for widebody aircraft.

The outlook for the recovery of global air passenger volumes has deteriorated in recent weeks as European countries have reintroduced quarantine measures and travel restrictions remain in place globally particularly on long haul routes that are critical to Rolls-Royce's engine fleet. This is expected to drive a weak recovery in the fourth quarter of 2020 and during 2021, and may put further pressure on demand and production rates for large commercial aircraft. As a result Moody's expects the sector recovery to be at the lower end of its expectations. This is partially mitigated by the company's relatively young aircraft engine fleet and broad geographic mix of markets served. Rolls-Royce assumes in its "severe but plausible downside scenario" outlined its half-year results, that engine flight hours will reduce by 64% in 2020 compared to 2019 and recover by 28% in 2021, i.e. remaining 55% below 2019 levels. Given the current outlook there is a high probability that flight hours are in line with or worse than this scenario.

At its half year results the company's auditors emphasized going concern issues in the event that the severe but plausible downside scenario occurs, which would require additional funding in order to maintain sufficient liquidity. This would include the replacement of the company's GBP1.9 billion revolving credit facility maturing in October 2021, and further funding over and above. Cash outflows in a weaker recovery scenario would be driven by engine shop visit costs, which Moody's does not expect to reduce in line with flight hours, and potential costs of over-hedging of foreign exchange.

The company has stated that it is evaluating potential fund raising including up to a GBP2.5 billion equity rights issue, and additional debt issuance. Whilst this would be credit positive Moody's expects these transactions primarily to address liquidity concerns rather than materially repair the balance sheet. There remain risks that additional financing would still be required depending on amounts raised and the evolution of trading, which if not addressed could lead to further pressure on ratings.

The company has also reported its intentions to dispose of certain trading assets, including ITP Aero, with target proceeds in excess of GBP2 billion. Moody's does not include any disposals in its credit assessment at this stage in view of uncertainties over execution.

In August Rolls-Royce reported that blade deterioration in the intermediate pressure turbine had been detected on around 20% of its XWB-84 engines of 4-5 years' service. The company is replacing the blades as a precaution at existing shop visits and does not expect material additional costs. The XWB has been a successful programme with strong performance to date. Rolls-Royce does not yet know the cause of the problem and therefore cannot give absolute certainty over fix costs, although the costs of the interim solution should be relatively predictable. Moody's considers there remains a low risk of a material issue arising, but it is an unwelcome development and takes the company one step closer to a larger problem, however low risk at this stage.

Moody's considers that the potential for support from the UK Government (Aa2, negative) remains high, as evidenced by the recent guarantee from UK Export Finance in support of the company's GBP2 billion term loan. The UK Government retains a "golden share" in Rolls-Royce which limits individual share ownership and indicates the company's strategic importance.

ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS

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 maintains substantial levels of liquidity, although this needs to be considered in the context of material cash outflows and downside recovery risks. 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 due in October 2021 and pro forma for a new GBP2.0 billion five year term loan partially guaranteed by UK Export Finance. The company also has a fully drawn GBP2.5 billion revolving credit facility due in 2025, and in addition to the GBP1.9 billion revolving credit facility has around GBP1.3 billion of debt maturities across the second half of 2020 and in 2021.

Moody's forecasts cash outflows over the next 18 months in the range of GBP2-3 billion, and also needs to meet working capital and seasonal liquidity requirements. There remains uncertainty and downside risks over liquidity headroom in the context of execution of restructuring and cost savings and the evolution of the recovery in demand.

STRUCTURAL CONSIDERATIONS

The company's EMTN programme is rated (P)Ba3, and its senior unsecured notes issued under this programme are rated Ba3, 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 below 5.5x, 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 Ba3 rating following the coronavirus outbreak, in particular if:

- Moody's-adjusted debt / EBITDA is not reduced sustainably below 6.5x, 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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