27 November 2019 by jbchevrel
Rolls-Royce PLC (ROLLS) manufactures aero, marine, and industrial gas turbines for civil and military aircraft. The company designs, constructs, and installs power generation, transmission, and distribution systems and equipment for the marine propulsion, oil and gas pumping, and defense markets. Today the CDS underperformed (ROLLS 5y CDS at 92.5 +5 while Main flat just below 48) after they got downgraded by S&P to BBB-, on the long-term rating. The outlook remains negative. This downgrade was due to increased cash costs related to the Trent 1000 engine, as well as an anticipated £1.2B charge to its FY19 P&L. Trent 1000 raised the main challenge for ROLLS, along with restructuring efforts, and costs associated with the A380. S&P had said that debt/EBITDA below 2x was required over the next 12-18 months to keep its BBB+ rating. H1-2019 results published on Aug 6 had shown further progress with the ROLLS recovery strategy. Core revenue was up +7%y (mainly thanks to Civil Aerospace +11%y), EBIT was up +32%y. FCF was negative (-£0.4B) partly due to seasonality and inventory builds for both Civil Aerospace and Power Systems. ROLLS management had guided toward +£1B free cash flow for FY-2020. Cash also improved thanks to the disposal proceeds from the Commercial Marine unit (c£0.5B). The ROLLS 5y CDS had peaked at 112 (close) in early October. Then it tightened ~25 on the 5y, with the Brexit risk premium compression (Great British Peso rally). ROLLS had spent £100M preparing for a hard Brexit (mainly through inventory build) fearing a supply chain disruption in the medium term. This risk has clearly diminished. In November the 5y CDS gyrated around 90 with no clear direction, despite the Main coming from ~52 to ~48. Going forward, the UK election could be a theme. We have had a notable underperformance of UK IG corporate CDS compared to UK holdco financial CDS, so that could correct around the vote.