The pandemic may have brought Rolls-Royce close to collapse but the FTSE 100 group’s engine troubles long pre-date the mass grounding of planes by international travel restrictions.
Tufan Erginbilgic, who has just taken over the top job, has inherited an industrial giant with much to prove to investors. His chief tasks? Demonstrating that the core civil aviation business can sustainably generate cash, and winning back an investment-grade credit rating.
Specialising in producing and servicing engines for widebody aircraft flying long-haul routes meant that sales were badly hit by the grounding of flights during the pandemic, causing Rolls to burn through more than £5 billion over the past 2½ years. Warren East, his predecessor, set a target to be generating modest free cashflow during the second half of last year.
Rolls makes money from servicing engines, charging customers a fixed amount on a “per flying hours” basis. Large-engine flying hours have been steadily recovering but were still just 65 per cent of 2019 levels in the four months to the end of October.
The lifting of Covid restrictions in China presents one of the biggest opportunities to boost flying hours. Each percentage point of recovery against the pre-pandemic level adds around £30 million to free cashflow, Jefferies calculates. The brokerage thinks flying hours for last year will average 62 per cent and 95 per cent in 2024, which would equate to an extra £990 million in free cashflow.
Capitalising fully on the recovery in long-haul travel also relies on Rolls avoiding further operational mis-steps, which together with hefty restructuring charges blew a hole in the bottom line in the years immediately before the pandemic. Under East’s tenure, the shares have declined in value by two thirds.
Whether Erginbilgic is forced to trim medium-term targets for the civil aerospace business later this year will also be a test of investor confidence. The current goal is to accelerate revenue growth to an annual compound rate in the low double digits and improve the operating margin to the high single digits, compared with a 1 per cent margin in 2019.
How does Rolls plan to get there? First, by reducing the losses incurred when the company makes and sells a widebody engine, by consolidating parts suppliers and attempting to make the manufacturing more efficient. Second, by attempting to extend the lifetime of the engine so that it spends more time in the air. Achieving those targets will partly depend on to what extent the £1.3 billion in cost savings made since the pandemic began are retained.
Rolls has been quieter on plans for its power systems and defence businesses. The former, which sells diesel engines to sectors ranging from marine to the oil and gas industry, is typically more cash-generative. The defence business, whose largest customer is the US government, offers a more stable stream of cash. But the need to rid itself of its junk credit status means talk could turn to whether to offload one of those businesses and pay down debt. Power systems, which faces the greatest existential challenge with the switch to cleaner technologies, could be the more obvious candidate of the two.
The sale of ITP Aero in September went some way to repairing the balance sheet, with the proceeds used to pay back £2 billion in debt due to mature in 2025. That leaves the £4 billion drawn debt pile all charged at a fixed rate, and £7.7 billion in cash and undrawn debt.
Cash generated by the civil aviation business from this year will be growing from a low base. The bigger test will be whether Erginbilgic can forge a clear flightpath to profit growth.
ADVICE Hold
WHY The new chief executive could engineer improvements in Rolls’ cash generation
Pantheon International
The risk-averse attitude adopted by investors over the past 12 months has been bruising for those investment trusts focusing on private equity. But even within a sector severely out of favour, the discount attached to Pantheon International versus the value of its assets, which stands at 45 per cent, is greater than most of its peers.
Investors have not become more cautious without reason. Higher interest rates have increased financing expenses for trade buyers of private companies, who will seek a better acquisition price. There is naturally a greater lag in the impact of a higher cost of capital translating into lower valuations placed upon private assets than on publicly-traded companies. Equity market chaos has also stifled IPO activity — another key route for private equity investors to realise their investments.
The value of Pantheon’s assets fell by just shy of 3 per cent in October, the latest monthly update, to 479p a share. Over a 12-month period, that equated to a net asset value return of 21.5 per cent versus a loss of almost 3 per cent from the FTSE All-Share and MSCI World, the yardsticks the trust uses to measure itself. But just over 70 per cent of the portfolio valuation is dated at June 30, when interest rates in the US and UK were lower. Pantheon points to a gain averaging 31 per cent on investments realised, compared with their last valuation, over the past ten years. Then again, that too was during an era of historically low interest rates.
But the FTSE 250 investment trust has elements that merit its approach over some peers. Direct investments represent about 45 per cent of Pantheon’s portfolio, which brings the benefit of lower management fees. The trust is well diversified by company and geography, with the US the largest exposure, at about half of assets, and the biggest single name representing only 1 per cent of NAV. What’s more, only 4 per cent of the trust’s portfolio is invested in venture-phase companies.
Up until May, Pantheon’s assets had delivered an average annual return of 12 per cent since inception 35 years ago — but waiting for more proof on how the portfolio’s value held up as inflation raged at the end of last year would seem prudent.
ADVICE Hold
WHY The trust could report a worse decline in assets when it updates the market
