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
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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)
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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
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Client Service: 44 20 7772 5454
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