MAY 13TH, 2016

Fitch Affirms Rolls-Royce Holdings plc at 'A'; Outlook Negative

Fitch Ratings-Warsaw/London-13 May 2016: Fitch Ratings has affirmed Rolls-Royce Holdings plc’s (Rolls-Royce) Long-term Issuer Default Rating (IDR) and senior unsecured rating at ‘A’. The Outlook on the Long-term IDR is Negative.

The Negative Outlook reflects the challenges to cash generation the company is facing as a result of new programmes and weakness in some key end-markets, with key financial metrics, such as free cash flow (FCF) and gross leverage, unlikely to be commensurate with the current ratings in the short term.

Fitch believes that Rolls’ financial profile is likely to recover in the medium to long term due to restructuring measures improving the group’s cost structure, stabilisation in some key end-markets and programme execution. However, should the recovery stall or take longer than expected, leading to a prolonged period of weak cash generation, a downgrade is likely.

KEY RATING DRIVERS
Deteriorating Financial Metrics
2016 will see a material deterioration in earnings and cash flows as a consequence of reduced Trent 700 volumes and pricing, slower markets for maintenance and spare parts relating to the existing fleet of large aero engines, weak demand for corporate and business jet engines as well as further deterioration in the marine division.

Restructuring measures are likely to aid the recovery of key metrics over the medium term, but the ratings could be downgraded if the company’s cash generation does not return to historical levels from around 2018. This would be in line with our expectations of the company exiting the costly ramp up and programme transition phase of the product life cycle.

Financial Measures Outside Guidance
Fitch expects Rolls-Royce’s funds from operations (FFO) gross adjusted leverage to exceed the negative rating guideline of 2x until cash generation builds up after the investment period. We do not expect the strained leverage metrics over 2015-2017 to be a long-term feature of the company’s financial profile. Net leverage remains in line with our expectations for the rating. The USD1.5bn bond issue in October 2015 lifted gross adjusted debt to GBP4.8bn at end-2015, from GBP3.7bn at end-2014. The bond issuance provides additional liquidity over the upcoming cash absorption period but has increased FFO gross adjusted leverage at end-2015 to 2.7x from 2.0x at end-2014.

Resilient Business Profile
Rolls-Royce has demonstrated the ability to manage a broad portfolio of turbine-related assets and generate cash for several years despite industry challenges and wider economic pressures. The company is well placed to withstand potential declines in demand resulting from deteriorating market conditions, due to its business diversification, growing proportion of long-term service contracts, and cost-cutting measures.

Dividend and Buyback Cuts Supportive
The halving of dividend payments and suspension of the GBP1bn share buyback programme after purchasing GBP500m of shares by mid-2015 offsets lost earnings resulting from reductions in Trent 700 earnings over the next three years. The action provides some additional headroom and financial flexibility to maintain the company’s financial metrics as it enters a period of cash- absorbing programme launches and growth. . The buyback was funded with proceeds from the GBP985m sale of the energy gas turbine and compressor business to Siemens AG in December 2014.

Commercial Aerospace Outlook Positive
Rolls-Royce derives about half its turnover from the commercial aerospace industry, where the outlook for engine deliveries and service work remains positive. The production of large commercial aircraft – and the engines the company manufactures for them – is set to increase in the short to medium term, reflecting the strength and quality of the order book.

KEY ASSUMPTIONS
Fitch’s key assumptions within the rating case for Rolls-Royce include:
- Approximately flat revenue in 2016, with 3-4% increases per year over 2017-2019.
- FFO margin in 2016 to fall to around 9% due to marine weakness, low profitability on deliveries of newly launched programmes and low Trent 700 volumes and pricing. Cost reductions to partially offset pressure on earnings over the coming two to three years.
- Capex to trend towards 6% of revenue due to lower development work in the pipeline.
- No increase in dividend before 2018, rising incrementally thereafter.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to negative rating action include the following:
- Lease-adjusted debt/FFO ratio is sustained higher than 2x (2015: 2.7x, 2016E: 3.1x).
- FFO/revenue ratio of less than 11% over a sustained period (2015:11.5%, 2016E: 8.8%).
- FCF margin not recovering to 3% by 2018 (2015: -2.0%, 2016E: -0.8%).
- Fixed charge cover of under 7x (2015: 7.3x, 2016E: 5.8x).

An upgrade is unlikely in the absence of a material change to the group’s business profile, given that the company has reached a rating close to the highest Fitch deems achievable for the aerospace and defence industry.

LIQUIDITY
At end-2015, Rolls-Royce had committed long-term banking facilities totalling GBP1.8bn and GBP2.2bn of cash and short-term deposits (net of a GBP1bn adjustment for intra-year operational cash requirements). This compares with short-term borrowings of GBP419m. Rolls-Royce has a back-ended debt maturity profile and sound access to capital markets.