Rolls Royce released an unexpected trading update ahead of its half-year results on August 3. Performance in the first half is expected to be "materially" above market expectations and full-year guidance has been updated as a result.
First-half underlying operating profit is now expected to be in the £660m-£680m range, ahead of previous market expectations of £328m. This was driven mainly by a roughly £480m improvement in the group's important Civil Aerospace division.
Free cash flow is also expected to be in the range of £340m-£360m, ahead of previous market expectations of £50m. This is being driven by improved underlying operating profits in the group's three main divisions, which is more than offsetting cash outflows as inventory levels rise.
Full-year underlying operating profit and free cash flow guidance have also been upgraded, from ranges of £0.8bn-£1.0bn to £.2bn-£1.4bn and £0.6bn-£0.8bn to £0.9bn-£1.0bn respectively.
The shares jumped 21.4% following the announcement.
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Our view
Rolls issued a surprise trading update to tell investors its half-year numbers will be far ahead of market expectations.
Rolls Royce produces aeroplane engines for larger, long-haul planes. A huge amount of its revenue comes from servicing those engines, with business based on how many hours those engines spend in the air.
So it was encouraging to see so-called engine flying hours (EFH) rise from 65% to 83% of 2019 levels in the first four months of the year. Despite this, we think it'll be a while before EFH return to pre-pandemic heights. And until global flight hours are back to pre-pandemic volumes, there's a ceiling to how high Rolls Royce can fly.
Disposals and a huge restructuring effort have lightened the load of recent financial scars, and the transformation programme's showing early signs of success too - driving productivity improvements across the group's major divisions.
First-half underlying operating profits are now expected to be around double previous market expectations. That's being driven by a sharp swing back to profitability in Civil Aerospace as commercial volumes pick back up, and higher demand and margins in the defence division.
Free cash flow's also expected to land in at around £350m at the half-year mark - seven times higher than markets had originally been expecting. That comes despite the fact that Rolls has spent more cash building up its inventory levels to cope with the additional activity and constraints in supply chains.
Now it's back in positive free cash flow territory, Rolls should be able to keep pushing debt lower, which stood at £3.3bn at the last count. But given the group was sporting a negative equity position - meaning liabilities outweigh assets - we're skeptical about seeing any kind of dividend this year.
A multi-billion pound order book gives the group a good deal of visibility over future revenue. We expect the order backlog to grow further as the group benefits from a recovery in its end markets. It's also continued to win key contracts in its lucrative defence division.
Rolls' position in the defence and aerospace industry is enviable - high barriers to entry mean there are very few smaller competitors sniffing around. However, valuing that long-term opportunity is a challenge. Huge asset write-downs mean traditional valuation metrics - like Price/Book or Price/Earnings - don't tell the full story. For that reason, we've used Rolls' Price/Sales ratio in the box below to offer a valuation touch point as it indicates how much the market is willing to pay for each pound of expected sales. But it's not a perfect indicator since it doesn't account for debt or profitability - both of which are major points of focus for Rolls right now.
It looks like the worst is now over, but there's still plenty of work to be done. With no dividend on offer to make the wait more palatable, shareholders should be prepared to stomach some turbulence.
Environmental, social and governance (ESG) risk
The aerospace and defence sector is high-risk in terms of ESG. Product governance and business ethics are key risk drivers. Carbon emissions from products and services, data privacy and security and labour relations are also contributors to ESG risk.
According to Sustainalytics, Rolls Royce's management of ESG risk is strong. It has set up a safety, ethics & sustainability committee to oversee ESG issues and executive compensation is tied to performance on these issues. There is also a strong environmental policy, including a commitment to net zero and interim targets, and whistle-blower programme. However, ESG-related disclosure falls short of best practice.
ESG data sourced from Sustainalytics
Rolls-Royce key facts
All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
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