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Rolling in the deep

With the COVID-19 pandemic severely disrupting the travel industry, aero-engine giant Rolls-Royce is experiencing a period unlike any other in its long history. In order to combat the cash flow issues that are being faced by many across the industry, and the economy for that matter, Rolls-Royce have taken steps in the second half of 2020 to shore up its own balance sheet and “batten down the hatches” in the short-term.

Bleak financial position

With £3.2bn of debt falling due next year, the pressure on Rolls-Royce’s current cash flows are immense and rising. COVID-19 has disrupted air travel significantly, with travel restrictions and no-fly edicts being announced and maintained indefinitely. This is particularly evident for long-haul flights, a market in which Rolls-Royce primarily target its large aircraft engines. The problem is only compounded when you look specifically into Rolls-Royce’s business model — the company actually loses money on engine sales and only makes profits on the service and maintenance of engines when aircraft are flying. The pandemic has really paid tribute to the limitations of this business model and as such, Rolls-Royce has suffered immensely. Underlying revenue was down 24.4% (2020 H1 compared to 2019 H1) and the business started the second half of 2020 with £6.1bn of liquidity, compared to £6.9bn at the end of 2019. The bleak outlook has led analysts to forecast future cash outflows of approximately £1bn in 2021. The immediate need for liquidity is not unique to Rolls-Royce, but one for many businesses, of all sizes, across the global economy.

Raising capital

Rights issue

Rolls-Royce has devised a £5bn recapitalisation package, comprising a 60:40 split between debt and equity. Alongside an extension in an Export Finance loan facility by £1bn and a further £2bn issuance of corporate bonds, Rolls-Royce aim to raise £2bn in equity before the end of 2020. On October 27th, investors of Rolls-Royce Holdings Plc voted 99.5% in favour of a ten-for-three rights issue, at a price of 32p per share. This represents a 41% discount on the share price of 130p at announcement. This comes after significant discussions surrounding the inclusion of sovereign wealth funds in the equity raise, with the decision ultimately being pivoted on the basis of existing shareholders resisting dilution.

Bond issue

As well as the rights issue, Rolls-Royce has also tapped into the credit markets, with a £2bn issuance of six-year and seven-year bonds — at a coupon of up to 5.75%. This coupon is considered to be substantially large when compared to the 3.7% European benchmark for high-yield debt, reflected in the ICE Bank of America index. This bond issuance comes two years after the company issued ten-year bonds at a coupon of 1.625%, demonstrating how coupons have now ramped up in a concerted effort to attract investors, as well as the downgrades in credit ratings that Rolls-Royce has experienced recently. The S&P credit rating agency downgraded Rolls-Royce corporate bonds by two notches in May, marking their bonds as sub-investment grade for the first time in over 20 years. As a fallen angel (see Angel Jobson’s article), the £2bn issuance ranks as the third largest junk bond issuance this year, following Fiat Chrysler Automobiles NV (€3.5bn issuance) and the €2.25bn which financed the private equity buyout of ThyssenKrupp AG.

Restructuring

Raising both equity and debt will certainly strengthen Rolls-Royce’s liquidity in a time when it is needed most. By meeting a short-term requirement, this strategic decision allows for the company to focus on restructuring its business, with strategies already in place to cut 9,000 jobs, save on a third of management costs, and ultimately achieve a £1.3bn target for cost savings this year. This rationalisation strategy and “tightening of the belt” is likely to lead to the sale of £2bn in assets, with Spanish parts maker ITP Aero in the firing line. The aero-engine group is set to reduce its number of worldwide sites from 11 to 6, in the biggest restructuring in its history, and consolidate wide-body engine assembly and testing at the main site in Derby.

Moving forward

The restructuring should enable Rolls-Royce to refine its business model in the medium-term and allow the company to repair its balance sheet moving forward. Although highly unlikely in the near future, Rolls-Royce should also aim to improve its credit rating in order to dictate more favourable credit terms on corporate debt. With a current coupon up to 2.05 percentage points above the European benchmark for high-yield debt, it is evident that improvements are needed for the long-term sustainability of the company.

The travel industry is one most definitely at the centre of attention, with continued uncertainty surrounding both public health and the economy. Not only are policy decisions crucial in getting planes back in the air, but consumer confidence plays a significant role in determining demand, particularly in an ageing population more susceptible to health risks when travelling. Tentative best-case scenarios from a sensitivity analysis suggest that long-haul flights are not set to return to pre-COVID heights until at least 2024. It is interesting to see that despite this fact, investors are still willing to support sectors worst hit by the pandemic-induced downturn, taking advantage of higher incentives (such as heavily discounted shares and higher coupons on corporate debt) due to the expectation of a recovery, albeit a prolonged one.

Sources

https://www.ft.com/content/d8ab7ea2-60a9-4737-bf9d-c0a8b57730d4

https://www.ft.com/content/feea2bfb-b5d7-4fd5-a2c9-b2429c5961e2

https://www.ft.com/content/2bb4ec23-e7a1-4b36-8eb4-e47f8271c440

https://www.ft.com/content/f8374ee9-43cb-4027-93a2-b2766aa89b03

https://www.bloomberg.com/opinion/articles/2020-10-14/the-rolls-royce-of-junk-bonds-has-arrived

https://cibsoc.co.uk/researchgroup/2020/10/12/fallen-angels-heaven-or-hell/

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