Rolls-Royce Is Lost In the Fog

Investors will have to take the recovery story on faith.
At Closing, April 25th
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Rolls-Royce’s financial statements are notoriously impenetrable. The 2016 vintage was no exception. While investors shouldn't get too hung up on a massive reported net loss, the British group's financial position looks weak, whatever metric you consider.

First, there's profit. The 4 billion pound ($5 billion) record yearly net loss reported on Tuesday was largely a function of the revaluation of the British aircraft engine maker’s massive currency hedge book. As a big exporter, the pound’s 14 percent slide against the U.S. dollar over the past 12 months will ultimately be good for the business, so investors can look beyond this non-cash accounting impact.

Revenue and underlying pretax profit actually beat market expectations, thanks in part to CEO Warren East's swingeing cost-cuts. So has the aircraft engine maker turned a corner? Hardly.

Under new IFRS 15 accounting rules due to come into force in 2018 -- for more on that see here -- the underlying pretax profit of 813 million pounds in 2016 would essentially have been wiped out. On the same accounting basis, Rolls-Royce would have reported a 600 million pound net loss in 2015, the notes to its financial statements show. Looked at in this way, Rolls-Royce hasn’t made any money for at least a couple of years.


Rolls-Royce has performed worse than the FTSE 100 over the past year


Now, let’s consider cash. Rolls-Royce generated 100 million pounds in free cash flow in 2016, some 44 per cent below the prior year but rather better than investors feared (the company is spending heavily on a new generation of aircraft engines).

Roll-Royce said it would generate similar free cash flow in 2017, but that excludes the 290 million pounds in payments due in 2017 to various authorities under a recent corruption settlement. That means Rolls-Royce will probably burn through cash in 2017, when investors had hoped cash flow would improve.

That’s unhelpful because the Rolls-Royce balance sheet isn’t in tip-top shape. While net debt is a modest 225 million pounds and the company has 5.1 billion pounds in cash and undrawn credit facilities, shareholder equity was just 1.9 billion pounds at the end of December. When you adjust that for roughly 3 billion pounds in negative impacts arising from IFRS 15, 1  Rolls-Royce effectively has negative net assets.

East has already cancelled a share buyback program and reduced the dividend. Even so, dividend payments consumed 300 million pounds of cash in 2016 and will demand another 200 million pounds in 2017. Given the large investment needs, plus an obligation to buy the other half of Spanish supplier Industria de Turbo Propulsores SA, it’s questionable whether Rolls-Royce should be returning cash to shareholders. 2

East argues that the cash flow troubles are temporary and things will be better by the end of the decade. For now, investors seem happy to allow him the benefit of the doubt, despite a 3.5 percent share price drop on Tuesday morning. Given the opacity of the company's forecasting, this is really a demonstration of faith alone.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. Rolls-Royce’s accounts show 2015 net assets would have been 2 billion pounds, not 5 billion pounds under IFRS 15. That's partly because the accounting rules will no longer allow Rolls-Royce to book upfront cash losses on engine sales as a balance sheet asset. 

  2. Rolls-Royce has the option to pay for the ITP stake in shares. 

To contact the author of this story:
Chris Bryant in Frankfurt at

To contact the editor responsible for this story:
James Boxell at

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