Fitch Ratings-London/Warsaw-17 February 2017: Fitch Ratings has downgraded Rolls-Royce Holdings plc’s (Rolls-Royce) Long-Term Issuer Default Rating (IDR) and senior unsecured rating to ‘A-’ from ‘A’. The Outlook on the Long-Term IDR is Stable.

The downgrade reflects Fitch’s view that Rolls-Royce will achieve a weaker than expected recovery in its key credit metrics such as free cash-flow generation and gross leverage beyond 2016 than was previously anticipated. Consequently, the company is likely to continue to have a credit profile which is no longer commensurate with the ‘A’ rating.

KEY RATING DRIVERS
Slower Improvement in Cash Generation: Our previous expectation that the company will return to free cash-flow (FCF) margins in excess of 3% in the short to medium term has been revised downwards and underpins the downgrade. We continue to believe that the funds from operations (FFO) and FCF margins will improve steadily in the next few years, but that improvement is now likely to take longer and be more gradual than previously envisaged.

Leverage Outside ‘A’ Rating Requirements: Rolls’ FFO-adjusted gross leverage, at 3.9x at end-2016, is expected to improve towards 2.5x by the end of the decade as the company’s FFO rises and its debt repayment capacity improves on the back of higher FCF and the absence of large bribery penalty payments after 2017. Nevertheless, the ratio is expected to remain firmly outside the 2x downgrade guideline over the next few years and is more in line with the ‘A-’ rating.

As Fitch focusses primarily on cash flows, the agency does not anticipate material differences to key rating ratios stemming from the adoption to IFRS15 in 2018, although it will continue to monitor the company’s disclosures relating to the transition. Currently, Fitch adjusts FFO for the Contractual Aftermarket Rights (CARs) relating to new commercial engine sales as this reflects the underlying dynamics of the company’s core cash flows.

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.

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.

Bribery Settlement of Minor Rating Impact: Our view is that the fines agreed between Rolls-Royce and a number of regulatory bodies in January 2017, will not, in isolation, have a material impact on the company’s key credit metrics. We estimate that the effect on gross leverage will be minimal as these cash payments are likely to be made chiefly out of the group’s ample cash reserves. The negative effect on net leverage from the payments is estimated by Fitch to be around 0.3x, which is not significant for the rating.

Brexit Risk Manageable: Fitch believes that the potential impact of a hard Brexit is likely to be mitigated by RR’s already globally diversified manufacturing and servicing base as well as a comparatively low World Trade Organization aerospace tariff regime. Some minor supply chain relocation and administrative cost increases may occur as a result of the UK leaving the EU customs union, but this is unlikely to be ratings significant of itself.

KEY ASSUMPTIONS
Fitch’s key assumptions within the rating case for Rolls-Royce Holdings plc include:
- underlying revenue to rise by low single digits over the short to medium term;
- FFO margin to rise gradually to around 10% by 2020 on the back of cost reductions and an improved mix in commercial aerospace;
- dividend to remain flat;
- capex to decline from its 2016 peak levels but remain at around 6% of revenue;
- no new material fines or penalties related to previous bribery investigations;
- no IFRS15-related adjustments made to the reported numbers.

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 3x (2016: 2.7x, 2017E: 3.1x);
- FCF margin not recovering to 2% by 2018 (2016: -2.0%, 2017E: -0.8%);
- fixed charge cover of under 5x (2016: 7.3x, 2017E: 5.8x).

Future developments that may, individually or collectively, lead to positive rating action include the following:
- lease-adjusted debt/FFO ratio below 2x;
- FCF margin above 3%;
- fixed charge cover above 7×.

LIQUIDITY
Healthy Liquidity: At end-2016 Rolls had committed long-term banking facilities totalling GBP2.3bn and GBP1.8bn of cash and short-term deposits (net of a GBP1bn adjustment for intra-year operational cash requirements). This compares with short-term borrowings of GBP172m. Rolls-Royce has a back-ended debt maturity profile and sound access to capital markets.