Cash crunch is just another crisis for Rolls-Royce

Rolls-Royce Trent XWB engine – Rolls-Royce In normal times, August should be a boom time for

Rolls-Royce Trent XWB engine - Rolls-Royce
Rolls-Royce Trent XWB engine – Rolls-Royce

In normal times, August should be a boom time for Rolls Royce.

It follows the traditional Farnborough and Paris airshows, staged in alternating summers, when the aviation industry shows off futuristic new technology, seals deals and generally schmoozes. Rolls typically entertains clients on the balcony of its multi-story chalet, allowing the flight displays to steal attention away from the company’s pre-existing problems.

Not this year, however. Covid-19 saw the aerospace jamboree cancelled, replaced by online seminars that did little to draw focus away from the catastrophic collapse in air transport.

Even the more optimistic predictions for the recovery of the airline industry expect it will be at least two years before there is a return to pre-pandemic levels, and that’s just for short-haul flights. 

With its large engines for wide-body jets Rolls is particularly focused on long haul; experts reckon this area of the civil aerospace market could to take five years to get back to normal.

To give an idea of the scale of the crisis facing Rolls, before Covid-19 struck about half of the company’s £15bn annual revenues came from selling and servicing airliner engines, much of it on “power by the hour” deals whereby customers paid only for what they used.

According to analysis by  consultancy Cirium, in January wide-body airliners powered by Rolls engines recorded about 22,000 flying hours per day. This plunged as low as 3,000 hours per day in early April, and is currently at about only 30pc of normal levels.

Flight hours chart
Flight hours chart

It’s no wonder that in the past few weeks Rolls shares have hit lows not seen in more than a decade, falling almost 70pc in a year.

Warren East, chief executive of the Derby-based giant, is doing everything he can to save the business in the face of what he has called an “historic shock to aviation”.

So far this has included making 9,000 staff redundant, some 15pc of the global workforce, as part of a tough cost-saving plan that follows on from earlier efficiency drives and disposals he has instigated since taking the controls five years ago.

At a trading update in July, Mr East revealed Rolls had burned through £3bn of cash in the preceding six months, a level expect to rise by another £1bn in the full year, while revenues fell by £1.1bn.

Coronavirus is only one of the problems Rolls is facing. Shortly before the pandemic hit, Rolls finally seemed to have got a grip on problems with its Trent 1000 engine used to power the Boeing 787 Dreamliner. 

First revealed by Rolls as a minor issue in 2016 as parts wore out earlier than expected, this snowballed into a £2.4bn bill with Dreamliners grounded because of fears of engines suddenly shutting down. This racked up compensation bills, expensive inspections, repairs and redesigns for what eventually turned out to be nine different problems. 

Markets Hub - Rolls Royce
Markets Hub – Rolls Royce

Now there’s a fear that history could repeat itself with Rolls’s flagship Trent XWB engine. Earlier this week the company said routine inspections of of XWB engines used to power Airbus’s A350 airliner had discovered cracks in some of the fan blades.

Rolls examined 100 early XWB engines – it has built about 800 so far – and said only a fifth of them had the issue, which does not require airliners to be grounded. 

The company also noted that, in part because of the collapse in air travel, it had the components and capacity to repair them, and costs would not be material.

But JP Morgan analyst David Perry, a noted bear when it comes to Rolls, warned “there are a number of a reasons to be wary: the Trent 1000 problems were initially considered minor but then escalated from a problem that cost £25m to between £2.4bn and £3bn”. He added: “Rolls does not yet know the cause of the cracks.” 

It’s just another problem for Mr East who has been dealing with constant crisis since taking the job, which started with him having to announce a profit warning on his second day as chief executive.

Warren East
Warren East

It’s not that Rolls hasn’t got the money to survive in the short term – and probably the medium term, too. The trading update announced £8.1bn of liquidity, including £2bn of credit from banks underwritten by state-backed UK Export Finance. Since the pandemic hit Rolls has raised £3.9bn in new financing and £300m from the Covid Corporate Finance Facility.

The problem is that this is not free money: it has to be paid back. And that’s going to be an issue with Rolls likely to experience five years of in doldrums before getting back to where it was. In a period of lower revenue, finding the money to repay the support could strain the company even further. 

Many see Rolls as a candidate for Project Birch, the Treasury taskforce set up to save Britain’s most important firms and whose failure could structurally harm the UK economy.

With more than 20,000 staff in the UK, many working on vital defence projects, failure is not an option for Rolls. 

However, the state taking a stake is seen as an anathema to Rolls. Even before state aid issues are considered, the company’s ability to operate would be slowed by government bureaucracy. In any case, Rolls still bears the scars of a previous nationalisation, when it had to be rescued in 1971 after costs of developing its advanced RB211 engine span out of control.

Trident submarine
Trident submarine

The legacy of that episode means the Government holds a “golden share” in Rolls, which prevents any single foreign investor from holding more than 15pc, and limits overseas ownership to 25pc in total. Still, desperate times may call for desperate measures.

More likely is selling the family silver. Last month The Telegraph revealed Rolls is in talks about a sale of Spanish engine component maker ITP. A year ago a similar deal that valued the business at about £1.5bn fell through, and in the current depressed market ITP might be worth only half that.

The latest Trent XWB issues might push that down further, or even make it impossible, as ITP has a significant stake in parts for the newly troubled engine. It would take brave buyer to ignore the risks of a repeat of the Trent 1000 debacle

There are other disposal options. Chunks of the power systems division, which makes engines used to generate power for the oil, gas and marine industries, as well as engines for yachts and trains under the MTU brand could be hived off. This could be a difficult sale; it is one of the best performing divisions and is helping prop up civil aerospace.

Rolls’ defence division could also be looked at, though this would come with huge security complications. Building and servicing engines for military aircraft has been almost unscathed by the pandemic making it relatively attractive. But a buyer would almost certainly have to be a UK business – such as BAE Systems – or extremely closely allied to Britain. 

Even this would mean a protracted and difficult untangling of Rolls’s nuclear operations, which provide the reactors for Royal Navy submarines and have to retain a sovereign capability.

The most likely outcome is an equity raise. Rolls has confirmed it is “looking at all options” and there have been reports of a £1.5bn rights issue, a sum equal to just under a third of the current market cap.

Whether this will be enough to support Rolls without a sudden pick-up in demand for air travel remains to be seen. 

According to JP Morgan’s Mr Perry, Rolls has “an £8bn hole and will need much more than a £1.5bn rights issue”, calculating the company needs to raise £6bn through disposals and other fundraisings.

Mr East’s crisis days are from over. 

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