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Rating Action:

Moody's downgrades Rolls-Royce to Baa1 from A3; outlook changed to stable from negative

13 Aug 2019

London, 13 August 2019 -- 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 Baa1 from A3. The outlook has been changed to stable from negative. Today's rating action reflects:

• High Moody's-adjusted leverage and low free cash flow generation

• Expectation that target free cash flow in 2019 will include working capital gains, which are not considered sustainable, and that 2020 target free cash flow may similarly be supported by working capital gains

• The rating also reflects the company's improving performance, expected growth in aftermarket earnings and long-term stability of engine programmes

Concurrently, Moody's has downgraded the rating on the company's senior unsecured Euro Medium Term Notes (EMTN) programme to (P) Baa1 from (P) A3, and downgraded the notes issued under the EMTN programme to Baa1 from A3.

RATINGS RATIONALE

The company's Baa1 senior unsecured rating reflects: 1) the company's strong business profile supported by an order backlog of more than 4x 2018 underlying revenue; (2) high barriers to entry given the critical technological content of the company's engines; (3) the positive outlook for aerospace and defence and for some niche segments in the company's power systems division; (4) the company's commitment to a conservative financial profile and (5) strong liquidity.

The rating also reflects: 1) high Moody's-adjusted leverage of 5.3x as at June 2019, which Moody's expects to remain above 4x over the next 12-18 months; 2) high costs of rectifying problems on the Trent 1000 engine programme, with ongoing execution risks; 3) limited free cash flow (FCF) generation, and expectations that future growth in FCF will be supported by unsustainable working capital gains; 4) concentration risks with reliance on a small number of commercial aerospace engines for widebody aircraft; 5) risks in achieving growth in aftermarket profits, which depend on future engine maintenance costs.

In the six months ended June 2019 Rolls-Royce reported underlying revenue growth in its core business of 7%, with core underlying operating profit margin increasing by 60 basis points to 2.8%. The company has made several important steps towards improving longer term performance, including reducing the losses on the sale of large commercial engines, whilst achieving strong growth in commercial engine aftermarket revenues and in power systems. Moody's continues to expect the company to improve earnings and cashflow particularly as the installed base of engines grows.

However free cash flow for the first half of 2019 was negative, with an outflow of GBP391 million for the core business as reported by the company, due largely to seasonal timing of engine deliveries. Rolls-Royce has maintained its guidance of around GBP700 million and GBP1 billion company-adjusted free cash flow for 2019 and 2020 respectively, however this cash flow in 2019 will be supported by favourable working capital movements. In 2019 Moody's expects around GBP600 -- 800 million of working capital gains mainly from inventory reductions and defence contract advance payments, and considers that the achievement of 2020 target cash flows is also likely to have to rely on further inventory reductions. Moody's does not view these working capital gains as sustainable in the long term and as a result the quality of underlying cash flows is lower than expected. Moody's also notes that the level of deferred revenue included in cash flows from receipts under aftermarket long term service agreements (TotalCare contracts) is likely to be lower than in 2018, which was enhanced by one-off contributions from a large aftermarket customer, and accordingly the likely growth in the deferred revenues in the company's cash flows from its TotalCare contracts is lower than previously estimated.

The company has also guided to an additional GBP100 million costs over the next two to three years associated with problems on its Trent 1000 engine programme, with the timeline for new product design and certification extending into 2020. It also expects lower growth in large commercial engine sales than previously forecast.

Moody's-adjusted leverage as at 30 June 2019 was 5.3x and the previous A3 rating was predicated on expectations of significant reductions in leverage alongside cash flow reaching the company's targets without the support of short term working capital gains. Moody's now expects a slower pace of growth in underlying cash flows. Moody's expects the company to continue deleveraging, supported by growth in the aftermarket engine installed base, increased flying hours, reductions in new engine losses and cost savings. As a result leverage is expected to reduce towards 4x in the next 12-18 months.

Rolls-Royce continues to maintain strong levels of liquidity. As at 30 June 2019 the company's total liquidity amounted to GBP6.7 billion, comprising cash on balance sheet of GBP4.2 billion and GBP2.5 billion undrawn bank facilities available until 2024. Short term borrowings and lease liabilities as at 30 June 2019 amounted to GBP464 million which are expected to be met from balance sheet cash. Whilst cash balances are enhanced by receipts in advance from customers, notably on TotalCare contracts, Moody's expects levels of deferred revenues to continue to increase for at least the next 12-18 months and therefore such contracts will not absorb cash.

OUTLOOK

The stable outlook reflects Moody's expectations that the company will delever towards 4x (on a Moody's-adjusted basis) over the next 12-18 months. It assumes that the company will continue to grow free cash flow on a sustainable basis, (excluding working capital gains, but including movements in long term service agreement deferred revenue) over the next 12 -18 months. It is further assumed that the Trent 1000 engine issues are resolved without further material increases in expected costs or additional delays, and aftermarket margins are sustained when recent engine programmes commence their first shop visits. The outlook also assumes that the company will maintain a conservative financial policy and strong liquidity.

WHAT WOULD CHANGE THE RATING UP / DOWN

The rating could be upgraded if:

• The company achieves solid revenue growth accompanied by improved profitability, including operating profit margins sustainably exceeding 10%

• Leverage reduces sustainably towards 2.5x on a Moody's-adjusted basis

• Moody's-adjusted FCF / debt increases sustainably above 10%

• The company maintains solid liquidity and a conservative financial policy

The rating could be downgraded if:

• Moody's-adjusted debt / EBITDA fails to reduce sustainably towards 4x in the next 12-18 months and fails to trend towards 3.5x thereafter, especially if not sufficiently balanced by cash on balance sheet

• Moody's-adjusted FCF / debt reduces sustainably below 5%

• There are signs of a weaker business profile, including a weakening in the company's market positions, or lower than expected aftermarket profitability

• The company adopts more aggressive shareholder return initiatives and financial policies, or there is a substantial reduction in liquidity

The principal methodology used in these ratings was Aerospace and Defense Industry published in March 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

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 2018 the company reported revenue of GBP15.7 billion and Moody's adjusted EBITDA of GBP1.3 billion.

REGULATORY DISCLOSURES

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.

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.

Martin Robert Hallmark
Senior Vice President
Corporate Finance Group
Moody's Investors Service Ltd.
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United Kingdom
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Richard Etheridge
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Corporate Finance Group
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