By Shalin Kothari and Matthew Landon
Background:
Rolls-Royce is a multinational engineering company based in London. They design, manufacture and service integrated power systems, and are the world’s second largest manufacturer of aircraft engines, as well as the world’s 16th largest defence contractor by revenue. The company does not make money from engine sales due to the price of an aircraft engine being below the cost of production, but instead the main source of Rolls-Royce’s profits comes from fees paid by airlines for the hours flown, plus after-sales maintenance (Capital, 2020). Therefore, with aircrafts remaining grounded due to the Covid-19 pandemic, it comes as no surprise that Rolls-Royce announced a record loss of £5.4bn in the first half of the year despite drastic cost-cutting measures including 9,000 job cuts worldwide (BBC, 2020). Rolls-Royce’s primary focus is on engines for larger twin-aisle aircrafts, meaning that it is expected to face a longer road to recovery than others in the civil aviation sector, with the resurgence of the long-haul market segment expected to come much later than short-haul and regional travel. In an effort to repair the significant damage to its balance sheet, the company are reportedly in talks with sovereign wealth funds as part of a plan to raise approximately £2.5bn from investors in October, leading to speculation about the future of Rolls-Royce.
| Rolls-Royce Holdings PLC | 31/12/2016 | 31/12/2017 | 31/12/2018 | 31/12/2019 | Latest |
| Price/Sales | 0.741 | 1.099 | 0.934 | 0.804 | 0.224 |
| Price/Earnings | – | 4.751 | 11.52 | – | – |
| Price/Free Cash Flow | 22.82 | 102.09 | 23.13 | 14.62 | 5.857 |
| Price/Book | 2.938 | 4.985 | 19.81 | – | -0.95 |
| Earnings Yield % | -19.13 | -6.31 | 8.68 | -9.86 | -180.9 |
| Enterprise Value ($Bn) | 16.60 | 22.63 | 19.15 | 15.96 | 6.858 |
| Enterprise Value/EBITDA | -4.74 | 3.87 | -10.30 | 26.33 | -5.46 |
Overview:
As of 25th September, the Rolls-Royce’s share price sits a 17-year low of 147.15 after a 78% drop since the start of the year. Earnings yield has fallen significantly, and enterprise value has dropped to less than half of its value at the start of the year. According to Rolls-Royce CEO Warren East, it will take five years for global air travel to return to pre-Covid-19 levels, and in the meantime, airlines are reducing their fleets to cut costs which taking its toll on Rolls-Royce’s revenues.
While the company’s defence business has kept them afloat during the Covid-19 pandemic, this has not brought in any significant profits for Rolls-Royce. A representative of Rolls-Royce released a statement in response to speculation of the need to raise new debt facilities to ease the severe strain on the company’s balance sheet due to the cash drain from the crisis.
“Amongst other options, we are evaluating the merits of raising equity of up to £2.5bn, through a variety of structures including a rights issue and potentially other forms of equity issuance. Our review also includes new debt issuance.”
- Rolls-Royce Holdings (FT 2020)
With this equity raise almost inevitable, the question is whether Rolls-Royce can weather to Covid-19 storm and emerge the other side as the global force that they once were in the civil aviation industry.
Analysis:
The data from Rolls-Royce’s financial reports indicate the turmoil endured by the company in recent years. However, to better understand the data, we must also consider the financial health of the company during this period. This is exemplified by the P/S ratio, the only remotely consistent metric for the last 5 years. Initially, the P/S ratio offers interest for investors having declined from over 1 in 2017 to almost 0.2 in September of 2020. On the face of it, it appears the stock is undervalued in this respect, but this is largely because revenues have stagnated, especially in recent months with demand for jet engines expected to half for 2020. Rolls-Royce have been pressured into selling their assets to raise the necessary funds to maintain operations in the long run.
The P/E ratio tells a similarly worrying story, having only been recorded for 2017 and 2018. Companies that report losses cannot record a P/E ratio which is testament to Rolls-Royce’s declining performance. Of the last 5 years, the firm has only reported positive annual net income in 2017 (Financial Times, 2020) which perhaps accounts for the spike in price/free cash flow in 2017. The P/FCF ratio has since fallen back down again reaching record lows in recent months, which can be attributed to 2 possible factors. Firstly, the free cash flow may have increased which may raise the eyebrows of buyers as this means Rolls-Royce may reward their shareholders through dividend payments, or potentially even further investment. Secondly, and much more likely in this case, share prices may have declined due to a fall in expectation of the company. Investors have evidently lost patience with the company churning out losses year on year causing the stock to plummet as mentioned before.
The P/B is currently negative, having spiked during 2017/2018 which proved to be a profitable period for Rolls-Royce. Prior to this, the P/B remained below 5 for most of this period and would potentially have been an attractive prospect for investors. However, the last 2 years have seen the P/B crash back down immediately after. Whilst P/B ratios under 1 are considered “solid” investments (although this is circumstantial), negative P/B values are extremely undesired as this implies the book value (total assets – total liabilities) is negative. This metric reflects the financial hardships endured by the company and given the current limitations for development, the chance of a rebound in the coming years is diminishing rapidly, with talks of a second lockdown in the US and UK. The firm’s enterprise value was heavily hit by the stalling of the aviation industry, dropping by almost $10bn in the last 9 months (as of September 2020), more than halving, and investors are finding it increasingly difficult to justify holding. The earnings yield has seen negative returns in 4 of the last 5 years and with the latest slump following the recent announcement of an equity issue within the company, the ship seems to be sinking further, which under a decade ago was unimaginable. The current earnings yield (-180.9%) is extraordinarily high, evidence that the lack of air travel and demand for jet engines has significantly reduced operating revenues.
The EV/EBITDA multiple has proven to be incredibly volatile in recent years, hitting a low in 2018 but almost immediately increasing to a high of 26.33 in 2019. This multiple considers the debt and cash levels as well as the stock price, giving some indication for the firm’s profitability. A low EV/EBITDA multiple relative to competitors may be a signal of undervaluation and compared to General Electric’s latest EV/EBITDA of 4.28 as of the 21st September, this may be the case for Rolls-Royce. However, as we know from the previous data, this is unlikely to be due to undervaluation, the low multiple (especially as it is negative) is more a signal of Rolls-Royce’s struggle to become profitable. A declining enterprise value as well as a negative EBITDA point towards negative returns for the foreseeable future.
Conclusion:
Recommendation- SELL
The question on most investors’ minds regarding Rolls-Royce is how low can the share price stoop? Is the current price the bargain price value investors can exploit or do the risks outweigh the potential rewards? From a purely analytical perspective, there is little for investors to be excited about. The consistent losses emerging from Rolls-Royce quarterly reports suggest the company is in nothing short of financial peril, despite recent efforts to combat the decline in services. Losses show no sign of recovery as of yet and many previous investors within the company have already jumped ship to cut their losses. Competitors within the industry such as General Electric and Pratt & Whitney have fared significantly better during the pandemic, evidenced by relatively strong enterprise value growth. It seems whatever Rolls-Royce do, they can’t find a way to stop the leaking of profits, and the consequences are being felt more than ever before. Investors shouldn’t confuse the company with an undervalued stock, as the underlying financials simply do not align with this idea. This makes it incredibly difficult to justify a buy given current market conditions and the future of the industry in the coming years. Rolls-Royce like many other firms has fallen victim to coronavirus, which goes to show that some industries have experienced irreversible damage.
Despite the company’s defence business keeping them afloat throughout the Covid-19 pandemic, the cost-cutting measures that have been implemented are likely to have a huge impact in the coming years. To make matters worse, Rolls-Royce’s focus on manufacturing large engines that are mostly installed on big liners for transcontinental flights means that it will continue to suffer losses even once manufacturers on smaller engines, such as General Electric and Pratt & Whitney, have recovered, as the analysis above suggests. Not only is Rolls-Royce struggling to make any significant profits, but it also lost its investment grade rating earlier this year, and on 11th August, the company announced some ‘abnormal wear’ on some of its XWB-84 engines installed on Airbus 350, meaning that they will have to check all of the XWB-84 engines in operation. This could hamper Rolls-Royce’s ability to secure new orders and long-term maintenance contracts when the market eventually begins to recover, meaning that even despite the planned equity raise in October, Rolls-Royce is unlikely to return to its former prosperity following the pandemic.
We recommend that investors avoid Rolls-Royce given the current demand for power systems, and the numerous complications under the surface. Rolls-Royce are currently faced with declining demand, poor financials, and significant uncertainty leaving investors with very little to be excited about, and given the recent rebound of other industries, their money would be best kept elsewhere.Page Break
Bibliography
BBC News, 2020. Coronavirus: Rolls-Royce considers tapping investors for £2.5bn. [Online]
Available at: https://www.bbc.co.uk/news/business-54223864
[Accessed 25 September 2020].
capital.com, 2020. Rolls-Royce share price history: from bad to worse to… better?. [Online]
Available at: https://capital.com/rolls-royce-share-price-history-from-bad-to-worse-to-better
[Accessed 25 September 2020].
Financial Times, 2020. Rolls-Royce Holdings PLC. [Online]
Available at: https://markets.ft.com/data/equities/tearsheet/financials?s=RR.:LSE
[Accessed 24 September 2020].
Financial Times, 2020. Rolls-Royce in talks with sovereign wealth funds to raise £2.5bn. [Online]
Available at: https://www.ft.com/content/6f53a18d-acd8-4a71-8902-60b1bb5f9c09
[Accessed 25 September 2020].
Industry Jargon:
- Price/Sales Ratio: The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value placed on each dollar of a company’s sales or revenues.
- Enterprise Value/EBITDA (EV/EBITDA): Enterprise multiple, also known as the EV multiple, is a ratio used to determine the value of a company. The enterprise multiple looks at a firm in the way that a potential acquirer would by considering the company’s debt. tocks with an enterprise multiple of less than 7.5x based on the last 12 months (LTM) is generally considered a good value.
- Enterprise Value: Enterprise value (EV) is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company’s balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover.
- Price/Earnings ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). P/E ratios are used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.
- Price/FCF ratio: Price to free cash flow is an equity valuation metric that indicates a company’s ability to generate additional revenues. It is calculated by dividing its market capitalization by free cash flow values.
- Price/Book: Companies use the price-to-book ratio (P/B ratio) to compare a firm’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share (BVPS). An asset’s book value is equal to its carrying value on the balance sheet, and companies calculate it netting the asset against its accumulated depreciation.
- Earnings Yield: The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of a company’s earnings per share. This metric is used by many investment managers to determine optimal asset allocations and is used by investors to determine which assets seem underpriced or overpriced.
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