Rolls-Royce's Mr Fix-It

Dividend cut makes sense, but skepticism about cash will linger

Warren East's halving of Rolls-Royce's next pair of biannual dividend payments is distinctly double-edged.

By knocking down a company totem -- the progressive (now temporarily regressive) dividend -- he's shown himself willing to act decisively to fix the aircraft engine maker's troubles. But the cuts are a reminder that the immediate outlook for cash and profit generation at Rolls-Royce is bleak.

The company expects negative free cash flow of up to 300 million pounds ($387 million) in 2016, compared to a positive 179 million pounds in 2015 and 447 million pounds in 2014.

Last year it halted a billion-pound ($1.45 billion) share buyback program as profit took a pounding because of weak demand from the corporate jet market, the oil industry and customers with service contracts on older passenger jets. Now shareholder returns are being curtailed further.

Rolls-Royce has promised to rebuild its dividend over time and investors were relieved there wasn't a sixth profit warning on Friday, as some feared. The shares bounced 13 percent. But the remedial action can only go so far. The dividend cut for 2015 saves about 120 million pounds, equivalent to just 8 percent of last year's pretax profit.

Disappointing Dividend

Rolls-Royce has been forced to cut its dividend to protect its balance sheet and credit rating

Source: Bloomberg data

2016 and 2017 are analyst estimates

In fairness, it's important for an aircraft engine-maker like Rolls-Royce to keep a strong balance sheet and investment grade credit rating. It relies on long-term debt finance to fund huge civil aerospace investment programs that take years to pay off. It also has maintenance agreements with airlines that stretch out for years.

Standard & Poor's gave Rolls-Royce reason to worry in January when it lowered the company's outlook to A/negative from A/stable. So East's move is understandable. Indeed, it's disquieting that a company that always maintained a large net cash position to support its business model has swung into net debt.

From Net Cash to Net Debt

Rolls-Royce's balance sheet is set to deteriorate but it needs to maintain that "A" rating

Source: Company reports and Bloomberg estimates

2016 and 2017 are analyst estimates

Rolls-Royce says once it gets through a period of heavy investment in new jet engines, cash flow will improve dramatically. But cutting the dividend, even for a short time, rather undermines confidence in the company's long-term planning and its belief those cash flows will be as strong as it claims.  

After all, East acknowledges deficiencies in Rolls-Royce's internal reporting systems, which forced him to retract medium-term guidance last year. So he'll forgive a bit of skepticism about the outlook being rosy after a couple of years of pain.

Consensus expectations for Rolls-Royce profit generation have fallen about 60 percent in the past year, while for 2017 earnings per share estimates have halved. While the surge on Friday reduces the share price decline over the past year, it's still down 33 percent.

Losing Altitude

A succession of profit warnings at Rolls-Royce have undermined investor confidence


Yet the shares are pricing in a lot of hope, trading at 21 times forward earnings, a premium of about one-third over civil aerospace peers.

Meanwhile, five-year credit default swaps on Rolls-Royce debt are near a record 172 basis points -- more than three times a year ago. By comparison, the Markit iTraxx Europe Index of CDS on investment-grade companies (including Rolls-Royce and many of the continent's strained banks) has risen to 124 basis points.

Fortunately for Rolls-Royce, aircraft demand remains buoyant. But if a global recession leads to fewer airline passengers, the equity market's vote of confidence in East's repair job will look premature.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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