Rolls-Royce Holdings. Moving to risk off. Addressing investor concerns. Forecast revisions. Valuation: Small premium to European large-cap peers

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1 Rolls-Royce Holdings Moving to risk off Post-H1 update Aerospace & defence H114 started with Rolls looking at a potential c 8bn acquisition of Wartsila, but has closed with a commitment to no near-term major deals. Rolls balance sheet now looks committed to the buy-out of Daimler s Tognum stake (c 1.9bn), while the c 1bn proceeds from the sale of the industrial gas turbines business to Siemens is to be returned to shareholders via a buy-back. Following a forecast pause in earnings growth in 2014, we see growth accelerating in 2016 as Trent engine deliveries pick up. We see fair value at 1,050-1,100p, with upside to this as and when Rolls can show accelerating growth and/or margin expansion towards its US peers. Year end Revenue ( bn) PBT* ( m) EPS* (p) 12/ , / , /14e , /15e , /16e , Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. Addressing investor concerns The fall in the Rolls-Royce share price since the start of 2014 was, in our view, driven by the combination of investor perception of heightened M&A risk (eg the DPS (p) P/E (x) Yield (%) Wartsila talks) and Rolls guidance for weaker 2014 earnings, as Defence profits fall and Civil Aerospace sees the upfront costs of preparing for sharply rising Trent deliveries from 2015-on. The 19 June 2014 Investor Briefing in our view addressed these concerns and issues, as well as those relating to Rolls accounting for longterm service agreements, following its discussions with the UK s Financial Reporting Council. Forecast revisions Our revised forecasts reflect Rolls updated guidance from the 1 May interim management statement, the effects of the industrial gas turbines divestment to Siemens, plus the planned 1bn share buy-back. Valuation: Small premium to European large-cap peers We value Rolls against six European A&D peers, and see the shares as trading at a premium of up to 9% out to 2016e. The premium largely reflects the depressing of Rolls near-term earnings and cash flow due to the near-doubling of Trent engine deliveries. We see fair value at 1,050-1,100p; to break out of the current price range we believe that Rolls needs to deliver on the CEO s margin ambitions, and move from the current c 12% towards the 15-16% levels of US competitors General Electric and United Technologies (parent of Pratt & Whitney). 15 July 2014 Price 1,050p Market cap 19,807m Net cash ( bn) at end 2014e 1.3 Shares in issue 1,886.4m Free float 100% Code Primary exchange Share price performance RR. LSE % 1m 3m 12m Abs (11.0) Rel (local) (14.1) 52-week high/low 1,272.7p 949.3p Business description Rolls-Royce produces aero engines and diesel engines, together with associated marine and power generation systems. Sale of an engine typically leads to a service relationship lasting two to three decades, generating high levels of recurring income and profits. Next events Farnborough Air Show H1 results Marine briefing and medium-term guidance Analysts July 31 July 21 October Sash Tusa +44 (0) Roger Johnston +44 (0) Jeremy Silewicz +44 (0) industrials@edisongroup.com Edison profile page Rolls-Royce Holdings is a research client of Edison Investment Research Limited

2 Company profile: Gas turbines, reciprocating engines, marine systems, nuclear Rolls-Royce is global producer of power systems, and is increasingly focused on two major technology areas: 1. Gas turbines, for civil aircraft (where it is the world number two producer, behind General Electric, and just ahead of Pratt & Whitney), military aircraft (world number three position), and naval ships. 2. Reciprocating (diesel) engines, based around the former Tognum and Bergen businesses. Applications include ships, power generation and agritechnical use, as well as heavy civil and military vehicles. The company s broader Marine portfolio also includes a range of ship components, sub-systems and design services, which both support and are supported by the sale of engines. Rolls also develops and supports nuclear powerplants for UK submarines, and has an emerging capability in civil nuclear programmes. Rolls groups its civil and military aero engine activities as Aerospace, and its remaining businesses as Marine & Industrial Power Systems (MIPS). Exhibit 1: Rolls-Royce: summary forecasts and valuation m e 2015e 2016e Share price 14 July ,050 Shares in issue m 1,886 Mkt cap m 19,807 Revenues 12,161 15,513 15,130 15,285 16,625 Underlying profit before financing 1,470 1,835 1,755 1,805 1,985 Operating margin 12.0% 11.8% 11.6% 11.8% 11.9% Pre-tax profit 1,409 1,763 1,655 1,640 1,825 EPS p DPS p P/E x Dividend yield 1.9% 2.1% 2.2% 2.4% 2.6% EV/Sales (adjusted average net debt) 166% 131% 136% 137% 126% EV/EBITDA (adjusted average net debt) x Sources: company historical data, Edison Investment Research calculations and estimates Exhibit 2: Rolls-Royce 2015e sales by sector Energy & nuclear 4% Marine 12% Power systems (diesels) 20% Defence aerospace 14% Civil aerospace 50% Exhibit 3: Rolls-Royce 2015e EBIT by sector Power systems (diesels) 18% Energy & nuclear 1% Marine 11% Defence aerospace 19% Civil aerospace 51% Source: Edison Investment Research estimates. Note: Charts reflect proposed sale of industrial gas turbines activities to Siemens, with completion estimated Q414e. Rolls-Royce Holdings 15 July

3 Investment summary Risk off, and repaying shareholders for their patience H114 has seen Rolls-Royce (and its shareholders) experience a rollercoaster ride in terms of the share price (down from an all-time high of 1,289p in early January to 961p at the end of February, largely in reaction to the company s announcement of an earnings pause in 2014e) and corporate development (the brief dalliance with a possible c 8bn bid for Wartsila, the announced sale of industrial gas turbines to Siemens, and the buy-out of Daimler s Tognum stake). In our view Rolls used the 19 June 2014 investor briefing as an opportunity to turn risk off, with the declaration that it has no major acquisitions planned, while the announcement on the same day of a 1bn share buy-back in effect rewards Rolls shareholders for their patience during the 2014 earnings pause. An attractive long-term story, but near-term fair value 1,050-1,100p The long-term investment case for Rolls remains intact and attractive: annual deliveries of the large Trent civil aero engines (which, at c 75% of the installed base by thrust, increasingly dominate the company industrially and financially) should, on our forecasts, double by 2018, locking in several decades of long-term service agreements (LTSAs, under the TotalCare brand when applied to Rolls civil engines). In the near term, however, such growth inevitably depresses earnings (new engine margins are minimal, especially compared to longer-term overhaul and support work) and cash flow. But, with concerns over Rolls accounting for such contracts largely allayed by the 19 June briefing, we would suggest that the combination of civil aerospace-related growth and annuity-style long-term services contracts (which comprise c 50% of revenues) should support near-term valuation multiple premiums; we see fair value at 1,050-1,100p on the basis of comparisons with a peer group of six large-capitalisation European aerospace and defence companies. Rolls needs to show that MIPS can grow, and Tognum is worth it To break out of this range (in the absence of major market moves that change the peer group valuations), we believe that Rolls needs to show both growth and margin expansion. The company forecasts growth to resume in 2015e, and we accept that the operational leverage of Trent volumes should overcome even the normal margin dilution of civil original equipment (OE) engine deliveries. Exhibit 4: We forecast MIPS to grow slower than Aerospace to 2016e Exhibit 5: And its margins to remain significantly lower CAGR e 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 5.5% 4.1% Aerospace (civil & defence) 2.7% 3.2% Marine & Tognum Margin (underlying profit before financing) 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 13.9% 13.3% 9.4% 10.1% e Revenues Operating profit Aerospace (civil & defence) MIPS (including energy & nuclear) Sources: Rolls-Royce historical data, Edison Research forecasts Sources: Rolls-Royce historical data, Edison Research forecasts Rolls-Royce Holdings 15 July

4 Beyond this, however, we remain to be convinced by Rolls MIPS businesses. In particular, Tognum has been a (mild but consistent) disappointment for us to date, with opaque financial and operational performance arguably made worse by the constraints of the JV holding with Daimler and German financial regulations. Rolls is committed to a further Investor Briefing covering Marine on 21 October 2014, and the Tognum activities in 2015; these could be key events for improving investor visibility into, and hence sentiment towards, MIPS. But margin convergence with the US peers would give substantial upside, if a tough objective Rolls also, in our view, needs to deliver on margin growth, especially towards the US peers General Electric and United Technologies; we were very encouraged that Rolls CEO John Rishton cited these companies (and their margins) at the 19 June briefing. The potential upside is clearly significant: 300+ basis points of additional margin, even if applied only to Rolls Aerospace business, would equate to m of incremental operating profits in e, an uplift of 16% at group level. However, we highlight Rolls small size relative to the two US companies, and question whether some of the margin shortfall might be a function of scale, an issue that the industrial gas turbines sale to Siemens might therefore worsen. Exhibit 6: Rolls needs to address whether its lower margins vs GE and UTX are just a function of poor efficiency, and hence an easy area of upside Exhibit 7: Or at least partially a function of Rolls significant scale disadvantage relative to the US companies Operating margins 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 15.1% 15.3% 15.7% 15.7% 15.9% 14.0% 12.0% 11.8% 11.6% e Rolls-Royce United Technologies General Electric (industrials) Turnover, $bn e Rolls-Royce United Technologies General Electric (industrials) 113 Sources: Companies historical data and guidance, Edison Investment Research forecasts Source: Companies historical data and guidance, Edison Investment Research forecasts Forecast revisions and sensitivities We have made extensive revisions to our forecasts and model (see Exhibit 17). These reflect not just Rolls plethora of H1 announcements, but also changes to the company s reporting structure and revisions to prior year figures. Key sensitivities that we see to our forecasts remain: FX (both the US dollar and, increasingly, the euro, following the full consolidation of Tognum). A weak correlation of Rolls cash flow compared to reported profitability. While we accept the logic for Rolls 2012 divestment of its share in International Aero Engines (IAE), we note that this effective exit from narrow-bodied aircraft engines means that the company has a heavily concentration on just four wide-body platforms, and a customer base that is only one-third the size of the narrow-bodied aircraft market. Changes in its market share on each of these (and/or their production rates) may therefore have a magnified effect on Rolls financials. Rolls-Royce Holdings 15 July

5 Exhibit 8: Rolls-Royce: key recent announcements and drivers of our revised forecasts Date Announcement/change Financial Impact years affected 13 February full-year results 2014 on A "pause" in 2014e revenue and profits growth. Defence down 15-20% due to completion of exports to Saudi Arabia and falling US volumes, especially for V-22 and C-130J. Growth forecast to resume in March 2014 Buy-out of Daimler AG's 50% share of Rolls on Valued at 2.43bn/ 1.9bn. Deal could complete in end-q3/early Q414. Royce Power Systems (Tognum) 1 May 2014 Interim management statement (IMS) 2014 Marine revenues and profits down 10% vs 2013 due to lower service volumes and 30m product quality charge. H1 free cash flow to be m below H113 ( 345m). 1 May 2014 Divisional restatement: transfer of Submarines 2012 on m revenues, 50-60m profit moved between divisions. from Marine to Energy & Nuclear 6 May 2014 Sale of industrial gas turbines and compressors to Siemens 2014, 2015 on Estimated 65m profit on transaction to be taken in FY m cash received at year end. Elimination of c 900m revenues and c 75m profits from 2015 on. 9 May 2014 Restatement of H113 results 2013 Includes restatement of risk and revenue-sharing agreements, and related tax effects. 19 June 2014 Proposed 1bn share buy-back 2015 on We assume all 1bn spent during 2015, FY effect on share count and finance charge in 2016 Source: Edison Investment Research, based upon Rolls announcements Exhibit 9: Rolls-Royce divisional breakdown and forecasts e Year to end-december, m FY FY FY H1 H2 FY H1 e H2 e FY e FY e FY e Total Revenues Civil Aerospace 4,919 5,572 6,437 3,201 3,454 6,655 2,900 3,970 6,870 7,720 8,770 Defence Aerospace 2,123 2,235 2,417 1,236 1,355 2,591 1,100 1,020 2,120 2,125 2,100 Marine 2,591 2,271 1,829 1,017 1,020 2, ,800 1,900 2,000 Energy & Nuclear 1,233 1,083 1, , , Power Systems (Tognum) ,239 1,592 2,831 1,275 1,650 2,925 3,100 3,275 Intra-segment (215) (143) (85) (62) (147) (95) (90) (185) (220) (255) Total Group Revenues 10,866 11,277 12,161 7,320 8,185 15,513 6,845 8,285 15,130 15,285 16,625 7% 4% 8% 27% 27% 27% -6% 1% -2% 1% 9% Underlying profit before financing Civil Aerospace ,110 Defence Aerospace Marine Energy & Nuclear Power Systems (Tognum) Central costs & eliminations (50) (52) (65) (29) (23) (52) (30) (25) (55) (60) (65) Total profit before financing 1,010 1,206 1, , ,105 1,755 1,805 1,985 3% 19% 22% 27% 23% 25% -22% 11% -4% 3% 10% UPBF margin Civil Aerospace 8.0% 9.0% 11.2% 14.1% 11.4% 12.7% 11.4% 13.4% 12.5% 12.4% 12.7% Defence Aerospace 14.6% 16.8% 16.3% 17.1% 16.8% 16.9% 15.9% 17.6% 16.7% 16.2% 16.0% Marine 12.8% 12.6% 12.8% 10.8% 12.1% 11.4% 7.6% 14.8% 11.1% 11.1% 11.0% Energy (& Nuclear from 2014) 2.2% 1.5% 5.6% 3.1% 6.8% 5.1% 3.4% 7.0% 5.3% 2.3% 3.4% Power Systems (Tognum) 24.2% 38.0% 5.8% 13.9% 10.4% 6.3% 13.9% 10.6% 10.8% 11.0% Total group margin 9.3% 10.7% 12.0% 11.4% 12.2% 11.8% 9.5% 13.3% 11.6% 11.8% 11.9% Underlying net financing (55) (49) (61) (32) (40) (72) (40) (60) (100) (165) (160) Underlying Pre-Tax Profit , ,045 1,655 1,640 1,825 Source: Company historical data, Edison Investment Research forecasts Rolls-Royce Holdings 15 July

6 Fair value 1,050-1,100p until growth resumes, margins expand We value Rolls-Royce against a peer group of European aerospace and defence large-cap companies, and see the stock as fairly valued in a range of 1,050-1,100p on a range of metrics: P/E Enterprise value against earnings before interest, tax, depreciation and amortisation (EV/EBITDA) EV against sales. Dividend yield. We also look at Rolls operating (pre-interest) margins, and compare these to EV/sales, to check that Rolls sales are not valued more or less highly than other companies with similar levels of profitability. Our peer group consists of: Safran and MTU Aero Engines, two direct European quoted aircraft engine peers, with similar business models and heavy weightings to civil engines and overhauls. Meggitt, whose aircraft wheels and brakes business has a similar business model and accounting to Rolls TotalCare approach, with any discount or loss on OE sales capitalised, and then amortised against subsequent high-margin spares and overhauls. Airbus, the other major European civil aerospace company. BAE Systems and GKN, two comparable FTSE100 large-cap industrials with large civil aerospace (in the case of GKN) and defence (BAE) activities. Rolls trades at (small) near-term premium to European peers: Margin convergence with the US peers is needed We note that Rolls trades at an average 6% premium to the peer group for e EV/EDITDA, falling to an average 4% EV/sales premium. The dividend yield averages 62bps below the peer group for all three forecast years. On our forecasts, Rolls operating margins average 31bps lower than the European peer group. This, compared to the EV/sales premium, suggests to us that the current valuation is pricing in a material improvement in operating margins (eg towards Rolls US peers) at the end of or beyond our valuation horizon. This highlights the importance of Rolls delivering on its aspiration to improve profitability towards its US peers GE and United Technologies (parent of Pratt & Whitney). Rolls-Royce Holdings 15 July

7 Exhibit 0: Rolls-Royce valuation relative to European A&D peers Share price e 2015e 2016e PE Safran ( ) MTU Aero Engines ( ) Meggitt (p.) Airbus ( ) BAE Systems (p.) GKN (p.) Average Rolls-Royce (p.) EV:EBITDA Safran MTU Aero Engines Meggitt Airbus BAE Systems GKN Average Rolls-Royce EV:Sales Safran 162% 151% 142% 133% 124% MTU Aero Engines 131% 118% 119% 109% 96% Meggitt 305% 290% 280% 260% 240% Airbus 65% 68% 68% 60% 55% BAE Systems 98% 97% 110% 115% 116% GKN 119% 111% 105% 97% 86% Average 147% 139% 137% 129% 119% Rolls-Royce 166% 131% 136% 137% 126% Operating margin Safran 10.6% 12.2% 12.6% 12.8% 12.9% MTU Aero Engines 11.1% 10.1% 10.1% 9.9% 10.1% Meggitt 24.4% 24.3% 23.9% 23.8% 23.7% Airbus 3.8% 4.5% 5.0% 7.4% 7.6% BAE Systems 10.4% 10.6% 10.5% 10.5% 10.6% GKN 7.7% 8.4% 8.5% 8.8% 9.0% Average 11.3% 11.7% 11.8% 12.2% 12.3% Rolls-Royce 12.0% 11.8% 11.6% 11.8% 11.9% Dividend yield Safran 2.0% 2.4% 2.6% 2.8% 3.0% MTU Aero Engines 2.0% 2.0% 2.2% 2.3% 2.5% Meggitt 2.4% 2.6% 2.7% 2.9% 3.2% Airbus 1.3% 1.6% 1.8% 2.4% 3.2% BAE Systems 4.7% 4.8% 5.0% 5.1% 5.3% GKN 2.0% 2.2% 2.4% 2.6% 2.8% Average 2.4% 2.6% 2.8% 3.0% 3.3% Rolls-Royce 1.9% 2.1% 2.2% 2.4% 2.6% Source: Edison Investment Research forecasts. Note: Prices as at 14 July 2014 Rolls-Royce Holdings 15 July

8 Sensitivities: FX, concentration and cash In our view Rolls-Royce s current three key sensitivities are: FX, specifically the exchange rates of sterling against both the US dollar and, increasingly, the euro. Customer concentration, in both civil aero engines and defence. Cash generation, especially the current mismatch between Rolls reported profits and underlying cash flow. FX: Traditional dollar exposure now being augmented by Tognum s euros Rolls has guided that the strength of sterling will, if the exchange rates seen in Q114 persist for the full year, reduce reported revenues by 300m, and profits by 40m. Rolls traditional FX exposure is the strength of sterling, in which Rolls reports, against the US dollar (in which the vast majority of its aero engine business is billed). This is essentially transactional; while Rolls is well-hedged (c.$5bn pa, around half Civil s dollar revenues), persistent sterling strength weakens Rolls competitiveness (clearly, in the absence of any changes to costs etc) against GE or Pratt & Whitney. We estimate Rolls dollar exposure to account for around two-thirds of revenues. An emerging exposure is the euro, with the full consolidation of Tognum. We estimate euro-denominated revenues now account for around 25% of pro-forma (postindustrial gas turbines) revenues. Greater customer concentration may accentuate revenue and earnings volatility With recent divestments and planned business sales, Rolls aero engine business is becoming increasingly focused on a relatively small number of customers. In Defence, following the sale of the RTM322 helicopter engine business to Safran, Rolls has three major government customers: The US government, The UK, and The Kingdom of Saudi Arabia. While Rolls remains a significant defence exporter, as well as being involved in collaborative engine programmes, the budget and programme profiles of these three customers on our estimates contribute the vast majority of Defence Aerospace s profits delta saw the completion of a phase of exports to both Saudi Arabia (engines for BAE Typhoon fighters) and India (BAE Hawks). This is a major contributor to the company s guidance for a 15-20% fall in 2014 Defence profits. The resumption of Typhoon deliveries to Saudi from 2015 could, however, cause profits to rebound later in the decade, as could the Hawk/Typhoon package for Oman from Rolls principal programmes for the US government are the AE2100 engine for the C-130J transport aircraft and the related AE1107 for the V-22 Osprey tilt-rotor. Production of both of these are falling in , but are clearly very sensitive to any new export orders. Rolls-Royce Holdings 15 July

9 We forecast deliveries of the F-35B variant of the Joint Strike Fighter, for which Rolls produces the LiftFan, to remain relatively stable at aircraft/engines annually out to 2020, before growing towards 25 pa (an estimated $400m of annual sales) in the next decade. Additional exports (e.g. to Australia, Japan or Spain) could increase post-2020 LiftFan production rates. Exhibit 10: C-130 and V-22 production rates are falling Number of aircraft deliveries C-130 production peaked in 2012, and so should now largely be reflected in Rolls' sales, but the big fall in V-22 production comes through in 2014 Textron has indicated that Israeli V-22s are likely to come out of USMC delivery slots Based on current backlog, C-130J stabilises at 16pa for the US, c 6pa exports e 2015e 2016e 2017e V-22 C-130J Source: Manufacturers historic data, Edison Investment Research estimates Exhibit 11: And F-35B only picks up again after e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022e 2023e 2024e US Marines UK Other exports Source: USAF/Lockheed Martin historic data, Edison Investment Research estimates Rolls-Royce Holdings 15 July

10 Civil programmes: (over-) concentration on widebodies A broader issue for Rolls is the degree to which, following the sale of the stake in International Aero Engines (IAE) to Pratt & Whitney, its civil engine customer base has become very concentrated, both in terms of customers (essentially long-haul airlines) and platforms (just three Airbus models, plus the Boeing 787). We assess the Trent 700 for the A330 to be Rolls dominant large engine at present, accounting for nearly two-thirds of all 2013 large engine deliveries. By 2017, we forecast the Trent XWB, for the A350, to have assumed this leading position. However, the relatively narrow customer base for both engines highlights the imperative for Rolls to re-enter the narrow-body aircraft market in the next decade. The recent cancellation by Emirates of its order for 70 A350s, comprising 8.6% of the entire order book, highlights the risk for Rolls of its current concentration on widebodies. Exhibit 12: After IAE, Rolls customer base has narrowed significantly Exhibit 13: Trent 1000 growth offsets the fall in Trent 700; Trent XWB is the driver of almost all net growth Number of operators/customers Airbus and Boeing's narrow-bodied aircraft families A320 family Boeing 737 family A330 and B777 are very mature wide-bodied aircraft programmes, but even they have fewer than half the number of operators of the narrow-bodied aircraft programmes A330 Boeing 777 A350 Boeing 787 A380 Engines In the absence of an A330NEO, we forecast A330 deliveries to erode post-2016 Rising Boeing 787 deliveries should largely compensate Rolls for a slowdown in the A330 Trent XWB for the A350 drives all of Rolls' net large civil engine growth Trent 700 (A330) Trent 900 (A380) Trent 1000 (B787) Trent XWB (A350) 2013 deliveries Estimated 2017 deliveries Source: Edison Investment Research, calculated from Boeing and Airbus websites Source: Rolls-Royce historical data, Edison Investment Research forecasts Cash mismatch with profits reflects the TotalCare debtor Rolls spent a large proportion of the company s 19 June 2014 Investor Briefing explaining and demonstrating the detailed workings of TotalCare packages, as Rolls brands its civil aero engine long-term service agreements (LTSAs). These can either be linked directly to the sale of an engine, or negotiated and delivered separately (e.g. where the aircraft and engine are owned by a leasing company, or where the engine is sold to the aircraft manufacturer before delivery to the airline). In either case, Rolls commits to providing power by the hour, guaranteeing the provision and cost to the airline of: Engine overhauls, Engine health monitoring, Reliability improvements, Management of the airline s entire fleet of identical engines, and Warranty services. By combining all of these in a total package, Rolls becomes totally focused upon maintaining the engine s performance in service. However, the financial incentive to reduce overhaul costs (which Rolls becomes responsible for) means that it must both design the engine for low cost of overhaul, and also manage its time on the wing; an unscheduled engine removal can cost up to $1m. A key challenge for Rolls (and its shareholders) associated with TotalCare packages is the mismatch between the company s reported revenues and profits, and the cash profile of the Rolls-Royce Holdings 15 July

11 contract. This can be seen clearly in the recent (and Edison forecasts for the next three years of the) relationship between Rolls underlying profit before financing (effectively operating profit) and operating net cash flow. Exhibit 14: Accounting for TotalCare packages means that Rolls cash flow is likely to remain below operating profits until Trent XWB deliveries peak after ,500 2,000 1,500 m 1, e 2015e 2016e Net cash flow pre-acquisitions/disposals Underlying profit before financing Source: Edison Investment Research calculations and estimates The major driver of this mismatch is the growth of Trent engine deliveries: 90% of Trents are covered by TotalCare contracts, which in turn drive the 50% of Rolls-Royce revenues accounted for by Services. TotalCare contracts include what Rolls has now agreed with the UK Financial Reporting Council (FRC) to call Contractual Aftermarket Rights (CARs). These allow Rolls to create aftermarket rights by use of warranties and compulsory spares supply in a TotalCare contract. Rolls therefore can continue to capitalise any cash loss on the original equipment (OE) delivery of the engine, amortising it against the TotalCare revenues. Combining OE and TotalCare aftermarket revenues also creates a positive margin that drives an increase in the debtor, and hence the disparity between profits and cash. Rolls therefore has cash mismatches at various stages of an individual engine contract that reflect, variously, any (capitalised) loss on the OE sale, the TotalCare power by the hour revenues, and then the (cash) costs of the eventual overhaul. At the highest level, Rolls therefore will report earnings ahead of cash as engine deliveries are growing strongly. This is clearly the case at least through 2017, as Trent XWB deliveries build up for the Airbus A350. However, as A350 deliveries plateau towards the end of the decade (we forecast at a rate of around 150 aircraft pa), Rolls expects the TotalCare debtor to reduce, and reported profits and cash should therefore cross over at that stage. This could, in the absence of a major new engine development (eg for a new narrow-body application), lead to very strong cash conversion. Rolls-Royce Holdings 15 July

12 Exhibit 15: We forecast Trent engine deliveries to grow 40%+ to 2016e... Exhibit 16: But installed thrust (and hence value) to increase c 50%, due to Trent XWB Engines Thrust lbf000s 35,000 30,000 25,000 20,000 15,000 10,000 5, Trent 500 Trent 700 Trent 900 Trent 1000 Trent XWB Trent 500 Trent 700 Trent 900 Trent 1000 Trent XWB Source: Rolls-Royce historic data, Edison Investment Research forecasts Source: Edison Investment Research, derived from Rolls-Royce data Rolls-Royce Holdings 15 July

13 Forecasts Exhibit 17: Rolls-Royce cash flow m e 2015e 2016e Reconciliation of cash flows from operating activities Operating profit 1,130 1,186 1,378 1,535 1,480 1,515 1,680 Profit on disposal of property, plant and equipment (10) (8) (9) 7 Share of results of joint ventures and associates (93) (116) (173) (160) (170) (180) (190) Dividends received from joint ventures and associates Amortisation and impairment of intangible assets Depreciation and impairment of property, plant and equipment Impairment of investments 3 2 Decrease in provisions 99 (28) (40) (17) Increase in inventories 41 (140) (158) 119 Increase in trade and other receivables 39 (62) (284) (533) Increase in trade and other payables (Total working capital) (200) (38) (175) (250) (325) Movement in other financial assets and liabilities (299) 68 (29) 9 Net defined benefit post-retirement cost/(credit) recognised in operating 147 (43) profit Cash funding of defined benefit post-retirement schemes (282) (304) (299) (315) (325) (335) (345) Share-based payments Net cash inflow from operating activities before taxation 1,508 1,514 1,474 2,278 2,065 2,050 2,165 Taxation paid (168) (208) (219) (238) (217) (204) (238) Net cash inflow from operating activities 1,340 1,306 1,255 2,040 1,848 1,846 1,927 Cash flows from investing activities Additions of unlisted investments (1) (1) Disposals of unlisted investments Additions of intangible assets (321) (363) (250) (503) (350) (400) (450) Disposals of intangible assets Purchases of property, plant and equipment (354) (412) (435) (669) (685) (660) (635) Government grants received Disposals of property, plant and equipment Acquisitions of businesses (net of cash acquired) (150) (19) (20) (37) Reclassification of JVs to subsidiaries 245 Acquisition of preference shares in subsidiary (34) Proceeds from restructuring of IAE 942 Disposals of businesses Investments in joint ventures and associates (19) (1,329) (24) (43) (1,900) Cash flows arising from loan to Engine Holding GmbH 0 (167) 167 Transfer of subsidiary to associate (1) Net cash inflow/(outflow) from investing activities (721) (2,207) 424 (740) (1,930) (1,040) (1,065) Cash flows from financing activities Repayment of loans (108) (567) (99) (133) Proceeds from increase in loans ,013 Net cash flow from increase/(decrease) in borrowings (40) (567) Interest received Interest paid (77) (50) (52) (58) (118) (186) (184) Decrease in short-term investments (326) 316 (313) Issue of ordinary shares 67 (1) 32 (1,000) Purchase of ordinary shares (124) (57) (94) (3) Dividend to NCI (60) Redemption of C Shares (266) (315) (318) (357) (445) (469) (498) Net cash outflow from financing activities (743) (655) (331) 136 (545) (1,634) (658) FX 17 (4) (54) (34) Change in cash & equivalents (107) (1,560) 1,294 1,402 (627) (827) 204 Source: Rolls-Royce historical data, Edison Investment Research forecasts Rolls-Royce Holdings 15 July

14 Exhibit 18: Rolls-Royce cash and borrowings, and adjustments to average net debt m e 2015e 2016e Cash 2,859 1,310 2,585 3,990 3,363 2,536 2,740 Short-term investments Short-term borrowings (717) (20) (149) (207) (207) (207) (207) Long-term borrowings (1,135) (1,184) (1,234) (2,164) (2,164) (2,164) (2,164) Net cash/(debt) at period-end 1, ,213 1,940 1, Average net cash/(debt) (145) (377) (275) Adjustments to RR reported net cash/(debt): Fair value of swaps hedging fixed rate borrowings (1) (1) (1) (1) Pension deficit (856) (287) (445) (793) (793) (793) (793) Adjusted period-end net cash/(debt) 677 (64) 872 1, (308) (104) Adjusted average net cash/(debt) (486) (444) (757) (1,171) (1,069) Source: Rolls-Royce historical data, Edison Investment Research forecasts Rolls-Royce Holdings 15 July

15 Exhibit 19: Financial summary Rolls-Royce m e 2015e 2016e Year to end-december UK GAAP UK GAAP UK GAAP UK GAAP UK GAAP UK GAAP PROFIT & LOSS Revenue 11,277 12,161 15,513 15,130 15,285 16,625 Cost of Sales (8,676) (9,432) (12,197) (11,801) (11,922) (12,968) Gross Profit 2,601 2,729 3,316 3,329 3,363 3,658 EBITDA 965 1,214 1,463 1,380 1,420 1,590 Operating Profit (before amort. and except.) 1,206 1,470 1,835 1,755 1,805 1,985 Intangible Amortisation Exceptionals Other Operating Profit 1,375 1,701 2,263 2,185 2,245 2,435 Net Interest (49) (61) (72) (100) (165) (160) Profit Before Tax (norm) 1,157 1,409 1,763 1,655 1,640 1,825 Profit Before Tax (FRS 3) 1,189 2,766 1,759 1,655 1,640 1,825 Tax (261) (311) (434) (397) (394) (438) Profit After Tax (norm) 896 1,098 1,329 1,258 1,246 1,387 Profit After Tax (FRS 3) 1,065 1,329 1,757 1,688 1,686 1,837 Average Number of Shares Outstanding (m) 1, , , , , ,812.0 EPS - normalised (p) EPS - normalised and fully diluted (p) EPS - (IFRS) (p) Dividend per share (p) Gross Margin (%) EBITDA Margin (%) Operating Margin (before GW and except.) (%) BALANCE SHEET Fixed Assets 8,144 8,553 10,245 10,475 10,710 10,950 Intangible Assets 2,882 2,901 4,987 4,907 4,867 4,867 Tangible Assets 2,338 2,564 3,393 3,703 3,978 4,218 Investments 2,924 3,088 1,865 1,865 1,865 1,865 Current Assets 8,315 9,593 12,818 12,366 11,789 12,318 Stocks 2,561 2,726 3,319 3,494 3,744 4,069 Debtors 4,009 4,119 5,092 5,092 5,092 5,092 Cash 1,321 2,596 4,311 3,684 2,857 3,061 Other Current Liabilities (6,943) (7,208) (9,780) (9,780) (9,780) (9,780) Creditors (6,923) (7,059) (9,573) (9,573) (9,573) (9,573) Short term borrowings (20) (149) (207) (207) (207) (207) Long Term Liabilities (5,114) (4,942) (6,980) (6,980) (6,980) (6,980) Long term borrowings (1,184) (1,234) (2,164) (2,164) (2,164) (2,164) Other long term liabilities (3,930) (3,708) (4,816) (4,816) (4,816) (4,816) Net Assets 4,402 5,996 6,303 6,081 5,739 6,508 CASH FLOW Operating Cash Flow 1,514 1,474 2,278 2,065 2,050 2,165 Net Interest (31) (41) (43) (100) (165) (160) Tax (208) (219) (238) (217) (204) (238) Capex (412) (435) (669) (685) (660) (635) Acquisitions/disposals (1,508) 1, (915) 0 0 Financing (58) (94) 29 0 (1,000) 0 Dividends (315) (318) (417) (445) (469) (498) Net Cash Flow (1,560) 1,294 1,402 (627) (827) 204 Opening net debt/(cash) (1,335) (117) (1,213) (1,940) (1,313) (486) Other 342 (198) (675) Closing net debt/(cash) (117) (1,213) (1,940) (1,313) (486) (690) Sources: Company historical data, Edison Investment Research forecasts Rolls-Royce Holdings 15 July

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