Moody's Investors Service has downgraded the long-term senior unsecured rating of Rolls-Royce plc 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, more than 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.
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 wide body aircraft.
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.
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 GBP 2.0 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.
