Rolls-Royce (RR.L) A focus on IFRS15 and FX. 6 April 2017 Europe/United Kingdom Equity Research Aerospace & Defense

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1 Europe/United Kingdom Equity Research Aerospace & Defense Rating UNDERPERFORM Price (04 Apr 17, p) Target price (p) (from ) Market Cap ( m) 14,104.6 Enterprise value ( m) 15,070.1 Target price is for 12 months. Research Analysts Share price performance 1, Olivier Brochet olivier.brochet@credit-suisse.com RR.L Specialist Sales: Andrew Bell andrew.bell@credit-suisse.com Ju l Ja n Ju l Ja n FT SE ID X The price relative chart measures performance against the FTSE 100 IDX which closed at on 04/04/17 On 04/04/17 the spot exchange rate was.86/eu 1.- Eu.94/US$1 Performance 1M 3M 12M Absolute (%) Relative (%) Rolls-Royce (RR.L) INCREASE TARGET PRICE A focus on IFRS15 and FX Earnings revisions: We increase our 2017E-2018E PBIT expectations by 4% and 2% (including c.3% from the full consolidation of ITP). At a divisional level, we increase Civil and Power Systems (rebound in order intake in some market segments flagged by our Cap Goods team) and cut Defence (more short term caution after CS Pentagon conference), Marine and Nuclear. IFRS15 accounting rule: We have not incorporated the potential impact of this in our model or estimates owing to the lack of detail. However, our initial assessment (which will need further refining) is that the group's PBIT could be revised down by GBP m per annum in E, before the headwind starts decreasing in 2019E, and that IFRS15-adjusted net income could show a small loss or breakeven in 2016 and 2017E. FX: We have restructured our model to better extract transaction impacts by branch. Based on our assumptions on GBP/USD and EUR/USD hedge rates, we calculate that c.50% of the E earnings increase would come from improved hedge rates. Catalysts and Risks: AGM and trading update on May 4 th ; H1 results in late July/early August; IFRS15 disclosure for 2016 accounts (maybe with the H1 results release). Risks: GBP/USD shifts, commercial aftermarket trends, pace of cost cutting; our valuation does not reflect any possible premium for a potential takeover of Rolls-Royce. Valuation: We revise our TP to 665p (vs 595p) using a 2018E SOTP (on non-ifrs15 numbers). We think that using post-2018e valuation metrics would capture a lot of the FCF upside but it would not reflect enough of the potential risks. Our blue sky scenario yields a valuation of 780p per share, based on a 5.5% FCF yield and our 2020E FCF of GBP1.05bn. A 12.5x P/E on 2020E EPS (IFRS15-adjusted) is the basis for our grey sky valuation (510p). Both the FCF yield and P/E correspond to the group's historical averages. Financial and valuation metrics Year 12/16A 12/17E 12/18E 12/19E Revenue ( m) 14, , , ,195.4 EBITDA ( m) 1, , , ,611.9 Pre-tax profit adjusted ( m) , , CS EPS (adj.) (p) Prev. EPS (p) ROIC (%) P/E (adj.) (x) P/E rel. (%) EV/EBITDA (x) Dividend (12/17E, ) Net debt/equity (12/17E,%) 37.3 Dividend yield (12/17E,%) 1.7 Net debt (12/17E, m) BV/share (12/17E, ) 1.4 IC (12/17E, m) 3,556.0 Free float (%) 99.2 EV/IC (12/17E, (x) 4.2 Source: Company data, Thomson Reuters, Credit Suisse estimates DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Rolls-Royce (RR.L) Price (04 Apr 2017): p; Rating: UNDERPERFORM; Target Price: (from p) p; Analyst: Olivier Brochet Income statement ( m) 12/16A 12/17E 12/18E 12/19E Revenue 14,955 14,901 15,394 16,195 EBITDA 1,635 2,012 2,286 2,612 Depr. & amort. (1,054) (1,014) (1,097) (1,192) EBIT ,402 Net interest exp. (102) (111) (112) (111) Associates PBT ,077 1,309 Income taxes 604 (230) (248) (288) Profit after tax 1, ,021 Minorities Preferred dividends Associates & other (374) (114) (240) (180) Net profit 1, Other NPAT adjustments (5,075) Reported net income (4,032) ,023 Cash flow ( m) 12/16A 12/17E 12/18E 12/19E EBIT ,402 Net interest (102) (111) (112) (111) Cash taxes paid Change in working capital Other cash and non-cash items 463 1,371 1,413 1,321 Cash flow from operations 1,252 2,173 2,460 2,813 CAPEX (585) (634) (620) (645) Free cashflow to the firm 67 1,121 1,128 1,714 Acquisitions (185) 0 (313) 0 Divestments Other investment/(outflows) (620) (720) (711) (554) Cash flow from investments (1,363) (1,354) (1,644) (1,199) Net share issue/(repurchase) (20) Dividends paid (215) (244) (282) (338) Issuance (retirement) of debt (434) Cashflow from financing (739) (281) (313) (351) Changes in net cash/debt (460) (379) (211) 271 Net debt at start ,176 Change in net debt (271) Net debt at end , Balance sheet ( m) 12/16A 12/17E 12/18E 12/19E Assets Total current assets 12,858 13,334 13,486 14,257 Total assets 25,538 26,768 27,651 28,562 Liabilities Total current liabilities 9,534 9,580 9,766 10,016 Total liabilities 23,674 24,177 24,511 24,738 Total equity and liabilities 25,538 26,768 27,651 28,563 Per share 12/16A 12/17E 12/18E 12/19E No. of shares (wtd avg.) (mn) 1,832 1,849 1,880 1,880 CS EPS (adj.) (p) Dividend (p) Free cash flow per share (p) Key ratios and valuation 12/16A 12/17E 12/18E 12/19E Growth/Margin (%) Sales growth (%) 9.0 (0.4) EBIT growth (%) (45.1) Net income growth (%) (14.0) (47.9) EPS growth (%) (48.4) EBITDA margin (%) EBIT margin (%) Pretax profit margin (%) Net income margin (%) Valuation 12/16A 12/17E 12/18E 12/19E EV/Sales (x) EV/EBITDA (x) EV/EBIT (x) Dividend yield (%) P/E (x) Credit ratios (%) 12/16A 12/17E 12/18E 12/19E Net debt/equity (%) Net debt to EBITDA (x) Interest coverage ratio (x) Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates Company Background Rolls-Royce is active in engines for civil (focused on large engines and small ones for business jets) and military aviation, in diesel engines for Power Generation and for Marine (+ associated deck machinery) and in nuclear equipment. Blue/Grey Sky Scenario Our Blue Sky Scenario (p) (from ) Our Blue Sky scenario corresponds to the situation where Rolls- Royce recovery is not hampered and by 2020 its FCF exceeds GBP1.0bn. We use a FCF yield of 5.5% on that horizon, in line with the group's historical valuation level. Our Grey Sky Scenario (p) (from ) Our Grey Sky valuation is based on a 2020E P/E of 12.5x (in line with historical average) applied to IFRS15-adjusted EPS. 1, Share price performance Jul- 15 Jan- 16 Jul- 16 Jan- 17 RR.L FTSE 100 IDX The price relative chart measures performance against the FTSE 100 IDX which closed at on 04/04/17 On 04/04/17 the spot exchange rate was.86/eu 1.- Eu.94/US$1 Rolls-Royce (RR.L) 2

3 Earnings revisions 2017E-2018E Following 2016 results released in February, we have restructured our Rolls-Royce model, in particular to better take into account transactional FX impacts (on revenues, gross margin and PBIT, with all revenues with transaction exposure accounted for at achieved hedge rates instead of part at spot rates as previously modelled). We also included 100% of ITP from H2 2017E onwards, assuming it would be paid in shares for half of the EUR720m consideration (calculated as 41m shares at 760p per share). We are increasing our 2017E-2018E operating profit expectations by respectively 4% and 1%. At a divisional level for 2017E and 2018E, we increase Civil and Power Systems and cut Defence, Marine and Nuclear. Our Defence expectations include some cautiousness on revenues and costs as a result of the Pentagon conference organized by our US colleagues on April (see 2017 Pentagon Conference Recap: Defense sector generally fully priced given likely outcomes). We expect some growth in Power Systems, with a view that some segments are now rebounding, such as mining equipment with order growth in Q3 and Q (see the March 30 Capital Goods End Market Analyser). The increase of Rolls-Royce's stake in ITP from 47% to 100% effectively boosts our PBIT estimates by 2-3% (+GBP30m p.a., assumed fully in the Civil Aerospace branch). Excluding ITP, our PBIT forecasts would rise 1% in 2017E and shrink 1% in 2018E. Figure 1: Old vs new forecasts in GBPm and p per share company definitions, pre-ifrs15 Reported Old New New vs old in % New vs old E 2018E 2017E 2018E 2017E 2018E 2017E 2018E Underlying revenue Civil 6,933 7,067 8,249 8,914 8,018 8,555-3% -4% Defence 2,035 2,209 2,312 2,494 2,281 2,230-1% -11% Power Systems 2,385 2,655 2,446 2,453 2,839 2,871 16% 17% Marine 1,324 1, , % -10% Nuclear % 6% Intra-segment % -48% Total 13,354 13,783 14,643 15,609 14,901 15,394 2% -1% Underlying PBIT Civil % 8% Defence % -4% Power Systems % 12% Marine % -41% Nuclear % -57% Holding % -8% 5 4 Total 1, , ,189 4% 1% Underlying margin Civil 11.7% 5.2% 4.8% 6.4% 6.1% 7.2% 1.2% 0.8% Defence 19.3% 17.4% 16.2% 15.0% 15.9% 16.2% -0.3% 1.1% Power Systems 8.1% 7.2% 7.5% 7.9% 7.3% 7.6% -0.2% -0.4% Marine 1.1% -2.4% -1.1% 2.2% -3.7% 1.4% -2.6% -0.8% Nuclear 10.2% 5.8% 8.0% 8.4% 2.9% 3.4% -5.0% -5.0% Total 11.2% 6.6% 6.5% 7.5% 6.7% 7.7% 0.2% 0.2% Other elements Net underlying finance charges % 12% Underlying PBT 1, , ,077 4% 0% 32 3 FCF % -12% EPS - underlying % -1% DPS % -17% Source: Company data, Credit Suisse estimates Rolls-Royce (RR.L) 3

4 Figure 2: CS forecasts vs consensus At FCF level, we are now expecting a modestly positive cash flow of GBP204m in 2017E, slightly ahead of company guidance ("similar to 2016"). We have marginally adjusted 2018E down. We are also cutting our dividend expectations, to reflect the starting point of the 2016 dividend and to reflect what we perceive as some uncertainty on future policy under IFRS15. Vs consensus Rolls-Royce has not released an updated consensus post 2016 earnings. We compare our revised numbers to the consensus as released on February 7 th. in GBPm and p per share company definitions, consensus as at 7 February Underlying revenue Reported CS Consensus (mean) CS / consensus E 2018E 2017E 2018E 2017E 2018E Civil 6,933 7,067 8,018 8,555 7,709 8,247 4% 4% Defence 2,035 2,209 2,281 2,230 2,155 2,175 6% 3% Power Systems 2,385 2,655 2,839 2,871 2,534 2,618 12% 10% Marine 1,324 1, ,090 1,128-9% -16% Nuclear % 9% Intra-segment % -48% Total revenues 13,354 13,783 14,901 15,394 14,151 14,844 5% 4% Underlying PBIT Civil % 15% Defence % 4% Power Systems % 1% Marine % -47% Nuclear % -50% Intra-segment % 12% Total PBIT 1, , ,140 4% 4% Operating margin Civil 11.7% 5.2% 6.1% 7.2% 5.4% 6.5% Defence 19.3% 17.4% 15.9% 16.2% 16.1% 16.0% Power Systems 8.1% 7.2% 7.3% 7.6% 7.9% 8.2% Marine 1.1% -2.4% -3.7% 1.4% -1.2% 2.3% Nuclear 10.2% 5.8% 2.9% 3.4% 7.1% 7.4% Total 11.2% 6.6% 6.7% 7.7% 6.8% 7.7% Other elements Net underlying finance charges % 20% Underlying PBT 1, , ,079 3% 0% FCF % -5% EPS (p) % 6% DPS (p) % -4% Source: Company data and consensus, Credit Suisse estimates Sizing up the IFRS15 impact We have not incorporated the potential impact of IFRS15 in our model or estimates owing to the lack of detail, and await Rolls-Royce's full disclosure on this before reviewing our numbers. However, we provide below an initial view on the possible consequences of the implementation on the group's PBIT and EPS. We would expect the impact to be strongly negative until Rolls-Royce (RR.L) 4

5 PBIT impact negative by GBP m over E Overall, based on our initial assumptions, we calculate that the PBIT of the group could be negatively impacted by IFRS15 adjustments to the tune of GBP m per annum over E, before a strong reduction in these adjustments in 2019E and 2020E. Most of the impact in Civil Aerospace, loss-making over E In November 2016, the group indicated that Civil Aerospace PBIT would have been negatively impacted by -GBP917m in 2015, with also a hit of about GBP3.5bn (pre-tax) on consolidated equity. As a result, Civil Aerospace would have been loss-making by -GBP105m in For 2016, we calculate an impact of at least GBP700m on PBIT for Civil Aerospace. Some of the elements of the switch to IFRS15 have been disclosed (such as the reversal of CARs and the reversal of the capitalisation of OE losses - identified with a * in Figure 3 and totaling -GBP324m), but some others are still unknown (such as the large engine cost incurred vs flight hours and the catch-up adjustments). For these, we understand that they are very volatile and could swing materially. At its February 2017 earnings presentation, the CFO stated that the number overall would be a bit lower than the c.gbp900m of We assume a total slightly above GBP800m for 2016 for Civil Aerospace, which would then have been loss-making by around GBP450m. The negative impact on equity is likely to have increased with the addition to TCP assets vs the GBP3.5bn indicated for Based on the elements we know, we would expect the negative impact on PBIT to increase in 2017E and stabilize in 2018E, before decreasing in 2019E and 2020E. As a result, we believe the Civil Aerospace business would be loss-making until 2018 and would post a small positive PBIT in 2019E. Limited impact likely on the rest of the business We have then assumed that the adjustments emanating from the rest of the businesses would be limited. They have not been disclosed, but we expect limited negative consequences in Defence and maybe Nuclear and non-material ones in Power Systems and Marine. We have provided for a negative annual adjustment of GBP30m (calculated as 5% of the PBIT of the non-civil Aerospace businesses). Rolls-Royce (RR.L) 5

6 Figure 3: Civil Aerospace from underlying to IFRS15-adjusted preliminary assessment in GBPm - * data already disclosed for FY16 in February 2017 ; other FY16 elements estimated Revenues E 2018E 2019E 2020E Revenues - underlying 6,837 6,933 7,067 8,018 8,216 8,322 8,817 OE 3,463 3,258 3,357 4,086 4,163 4,188 4,470 Aftermarket 3,374 3,675 3,710 3,932 4,053 4,134 4,347 Revenues IFRS15-adjusted 5,991 6,254 7,158 7,362 7,819 8,578 OE 2,524 2,706 3,330 3,385 3,689 4,176 Aftermarket 3,467 3,548 3,828 3,977 4,130 4,401 OE adjustments IFRS15 adjustments as detailed in November 2016 for FY15 No profit on linked OE sales * No capitalisation of linked engine cash losses * No CARS on unlinked contract * Treatment of guarantees (essentially Trent 1000 related) Total OE revenues adjustments No amortisation of CARs * No reversal of Trent 1000 impairment * Total OE profit adjustments Aftermarket adjustments No amortisation of prior year concession deferral * Reduced valuation policy adjustments * Other catch-up adjustment differences Large engine cost incurred vs EFH impact Corporate care cost incurred vs EFH impact Total aftermarket revenues adjustments Catch-up difference adjustment 35 Total aftermarket profit adjustments Gross margin Gross margin underlying 1,675 1,526 1,185 1,220 1,350 1,545 1,739 Total profit adjustment Gross margin IFRS15-adjusted ,042 1,500 Gross margin underlying in % 24.5% 22.0% 16.8% 15.2% 16.4% 18.6% 19.7% Gross margin IFRS15 adjusted in % 10.2% 5.9% 5.0% 6.7% 13.3% 17.5% PBIT PBIT underlying - Civil Aerospace Total profit adjustment PBIT IFRS15-adjusted - Civil Aerospace PBIT underlying - Civil Aerospace in % 13.8% 11.7% 5.2% 6.1% 7.6% 9.6% 11.0% PBIT IFRS15-adjusted - Civil Aerospace in % -1.8% -7.1% -5.1% -3.2% 3.8% 8.5% Source: Company data, Credit Suisse estimates Net income likely to show a small loss/breakeven in E after IFRS15 Based on these assumptions, the group's net income would have been marginally negative in 2016 (-GBP20m) and we expect 2017E to be breakeven (-GBP1m). Growth in IFRS15-adjusted results would kick off in 2019E, after a small benefit in 2018E. The decrease of the gap between underlying and IFRS15 profits combined with growth in earnings across the group would take overall net income to c.gbp990m in 2020E, broadly in line with FCF generation (which we estimate at GBP1.05bn in 2020E). Rolls-Royce (RR.L) 6

7 Figure 4: IFRS15 impact on EPS preliminary assessment in GBPm and p per share E 2018E 2019E 2020E PBIT - Civil Aerospace PBIT - rest of the group Group PBIT 1,681 1, ,190 1,420 1,645 Total PBIT adjustment - Civil Aerospace PBIT adjustment - rest of the group PBIT IFRS15 adjustment - total group Group PBIT IFRS15-adjusted ,375 Net income - underlying 1,226 1, ,023 1,201 Net income adjustment Net income - IFRS15 adjusted EPS - underlying EPS - IFRS15-adjusted Stock price P/E - underlying 14.8x 13.6x 22.4x 21.5x 17.3x 14.1x 12.0x P/E - IFRS15-adjusted 41.1x n/m n/m 95.7x 23.7x 14.5x Source: Company data, Credit Suisse estimates Valuation We value the stock at 665p per share (up from 595p previously), based on a 2018E SOTP (pre-ifrs15 adjustments). We believe that using pre-ifrs15 numbers for valuation allows a degree of comparability with historical data. IFRS15-based valuation remains very hazardous in our opinion, with only a small FCF generation in 2018E and no earnings or equity to value. We also believe that using post-2018e valuation metrics would capture a lot of the upside expected on FCF, but it would not reflect a number of potential risks: actual profitability of the current cash inflows, transition of older TCP contracts, aftermarket slowdown, R&D spending with new programme launches and Brexit. Rolls-Royce (RR.L) 7

8 Figure 5: 2018E SOTP in GBPm and p per share pre-ifrs 15 adjustments Sales Underlying PBIT margin EV/sales EV/PBIT Implied EV EV/share (p) % of group EV PBIT (%) (implied, x) multiple (x) Civil Aerospace 8, % 0.67x 9.3x 5, % Defence Aerospace 2, % 2.03x 12.5x 4, % Power Systems 2, % 0.94x 12.4x 2, % Marine % 0.50x 34.5x % Nuclear % 0.60x 17.7x % Intra-segment & HQ x % Total sales 15,394 1, % 11.2x 13, % Less: net capitalised R&D costs % 11.2x % Adjusted underlying PBIT 1, % 11.2x 13, % Less: net debt % Less: financial RRSAs % Add: pension surplus / Less: pension deficit (post-tax) % Less: customer financing % Less: minorities % Total valuation 12, % Number of shares 1,880 Source: Credit Suisse estimates Figure 6: EV/EBITA - Underlying (x) E 2018E 2019E 2020E EV/EBIT average Source: Company data, Credit Suisse estimates Longer term valuation conundrum We realise that our valuation as outlined above captures short term prospects only and effectively ignores the potential upside that would come from a significantly improved cash performance in the long run. We believe this improvement would be driven for Civil Aerospace by a combination of 1) lower OE losses, 2) higher aftermarket inflows, 3) FX benefits (see more on that further in this report), and 4) potentially an acceleration of a rebound in short cycle activities and a recovery in Marine orders from the oil & gas industry. Looking further into the future, we believe FCF metrics would capture the expected improvement in cash generation in Civil Aerospace highlighted in Figure 7. Rolls-Royce (RR.L) 8

9 Figure 7: EBITDA - Capex by branch in GBPm EBITDA calculated as underlying PBIT + D&A and impairment, capex as Investment in intangible assets, PP&E and JV and associates E 2018E 2019E 2020E Civil aerospace Defence aerospace Non-Aerospace activities Source: Company data, Credit Suisse estimates However, we believe that it is too early to fully factor in these elements in our valuation, with some potential fundamental downside risks that have yet to be assessed. Indeed, we are not comfortable with the underlying profitability of the future cash-flows in Civil Aerospace, with effectively XWB cash-flows flowing in ahead of the actual shop visits, with no visibility on the profitability of these and potentially bad surprises on realized shop visit costs once they start on this new engine. While we agree in principle that volumes should be helping saturate Rolls-Royce's shops and generate production efficiencies on spare part costs, we have no visibility on pricing of the aftermarket services and how it compares with previous products in terms of costs, while the group is in the midst of an indepth reorganization and cost reduction plan. We also see risk on how older Trent engines are transitioning from one operator to another, with a risk of seeing more operators drop out of TotalCare when their 15/17-year old engines come to the end of a TCP contract and opt for a time & material approach instead of renewing the TCP contract (resulting in a fall in cash inflow until the shop visit). This risk explains in our view the new SelectCare, TotalCare Flex and LessorCare offerings launched by Rolls-Royce in the last two years. Amongst other things, they aim at limiting the negative consequences of these transitions, but their practical impact remains to be measured (with only a limited number of customers signed on for the moment). Finally, we see risk on widebody traffic, which could weigh on Rolls-Royce's aftermarket, and we are unsure how R&D will trend in the future vs current plans, following 1) a potential new programme launch at Boeing, which we believe would be pursued aggressively by Rolls-Royce (as it needs to diversify in medium thrust engines and away from Airbus), and 2) Brexit, with question marks on funding coming from EU programmes and how this will be transitioned in the UK. Rolls-Royce (RR.L) 9

10 Figure 8: FCF yield Rolls-Royce vs peers Average of our coverage (accounting for 90% of the European sector by market cap): Airbus, BAE Systems, Dassault Aviation, Meggitt, Rolls- Royce, Safran, Thales, Zodiac 25% 20% 15% 10% 5% 0% E 2018E 2019E 2020E -5% Airbus Group BAE Systems Rolls-Royce Safran Thales Average Source: Company data, Credit Suisse estimates Blue sky valuation Figure 9: Blue sky target - sensitivity to FCF estimate in GBPm and p per share Assuming an FCF yield of 5.5% (corresponding to the average for the group) in 2020E (7.6% at current price) would take the valuation to 781p per share (1,014p per share discounted back to a 12-month target price). This is based on an FCF of GBP1.05bn. We would use this calculation as blue sky scenario. This number is very close to the current share price. Blue sky valuation 20% upside to current FCF forecast 20% downside to current FCF forecast Implied FCF from current share price FCF 1,046 1, ,027 FCF yield ( average) 5.5% 5.5% 5.5% 5.5% Valuation 19,071 22,886 15,257 18,728 Valuation per share 1,014 1, Discounted back to 12-month target (@ 10%) Source: Credit Suisse estimates of 767p An FCF of c.gbp840m in 2020E (i.e. 20% below our current estimate) would yield a discounted price of c.624p per share, 6% below our revised target price. Using the same assumptions, the current price and a 5.5% FCF yield imply an FCF of GBP1.03bn in 2020E, an amount aligned with the company's comments on its February earnings call. Grey sky Our grey sky valuation comes to 510p. It would correspond to our 2020E EPS (IFRS15- adjusted) with a P/E of 12.5x (average of the group for ) discounted back at 10% to a 12-month target. Using the same P/E, the current price implies EPS of 79.5p, 51% higher than our estimate. Rolls-Royce (RR.L) 10

11 Figure 10: Grey sky calculation in p per share 2020E as forecast Implied EPS at current price EPS 2020E IFRS15-adjusted P/E (average ) 12.5 x 12.5 x Valuation per share Discount to 12-month 10% Source: Credit Suisse estimates An attempt at measuring the currency impact Transaction exposure Here we make an attempt to extract from the group underlying accounts a view on the impact that its hedgebook has had and will have. Underlying revenues and PBIT are expressed at achieved hedge rates for the year, for all the parts that are subject to transaction exposure. This essentially concerns revenues in USD with costs either in GBP or in EUR (in the latter case, there is a further translation exposure from EUR to GBP). Revenues of the businesses with translation exposure (revenues and costs in the same currency) are accounted for at spot rates (essentially USD to GBP, EUR to GBP and NOK to GBP). The hedgebook Rolls-Royce has taken advantage of the weakness of the GBP and EUR to improve its average hedge rates. The GBP/USD hedgebook at end December came to USD38bn, representing 5-6 years of cover, at an average rate of This compares to a hedgebook of USD29bn at end 2015 at We have assumed a USD3.0bn annual replacement vs a EUR bn utilisation for the hedgebook. The EUR/USD hedgebook at end 2016 was at USD2bn, representing c.3 years of cover, at a rate of 1.29 (vs 1.35 at end 2015). The inclusion of 100% of ITP is likely to increase the net exposure. Figure 11: Hedgebook rates and estimated transaction rates for GBP/USD and EUR/USD E 2018E 2019E 2020E GBP/USD hedgebook rate EUR/USD hedgebook rate GBP/USD transaction rate EUR/USD transaction rate Source: Company data, Credit Suisse estimates for 2017E-2020E and transaction rates Rolls-Royce (RR.L) 11

12 Contrary to Airbus or Safran, Rolls-Royce does not disclose the achieved rate of any given year, just the variance between two years (-2.5 cents in 2016, immaterial in 2015). Moreover, some of the products used by Rolls-Royce have variable settlement dates, allowing for some in-year flexibility on the achieved rates and effectively making it unpredictable from outside. The transaction benefit in 2016 came to GBP20m, but the effective hedge gain was larger (we estimate it at GBP55m) and was partly offset by a negative revaluation of balance sheet elements. The group indicates that it does not expect a meaningful impact from the GBP/USD hedgebook in 2017, as most the hedges have been accumulated in past years at much less attractive rates. The impact of the improved GBP/USD rates will only be felt at the end of the decade. On the EUR/USD hedgebook, we however expect some more material change, but on a lower exposure. Transaction impact As a result, we have modelled that the achieved GBP/USD rate will improve by 1 cent in 2017E, 2 cents in 2018E, 3 cents in 2019E and 4 cents in 2020E. We have also assumed a 5-6 cent improvement on the EUR/USD rate in 2017E and 2018E, with gains of 1-2 cents afterwards. Nearly all of the GBP/USD impact is in Civil Aerospace, together with the largest part of the EUR/USD exposure. Power Systems also has a residual EUR/USD sensitivity. Based on these assumptions, we expect transaction benefits of GBP41m in 2017E and GBP65m in 2018E in Civil Aerospace. Figure 12: Transaction benefits estimated in GBPm benefits pre-balance sheet revaluation E 2016E 2017E 2018E 2019E 2020E Transaction benefits GBP GBP/USD rate change EUR/USD rate change Source: Credit Suisse estimates However, we recognize that the visibility on how Rolls-Royce will unwind its hedgebook is limited. We note that in September, Rolls-Royce was still expecting modest transactional benefits due to limited change in the achieved hedge book rate. At the end of the year, the actual change came to 2.5 cents. Assuming that the change in hedge rate would be 3 cents instead of 2 cents in 2017 for the GBP/USD achieved rate would boost the operating profit by GBP25m, based on our estimates. An improvement of 1 cent instead of 2 cents would reduce the estimated PBIT by GBP25m. Rolls-Royce (RR.L) 12

13 Translation impact Rolls-Royce also benefits at the moment of a favourable translation exposure, with some of its businesses in the US and some in Germany as well as in Norway, all of which have to be translated from the local currency to GBP, at average spot rates for the related currency. The USD exposure is essentially coming from Civil (regional jet engines and some of the corporate engines) and Defence (large US presence), as well as more marginally in the Power Systems and Marine branches. The EUR impact is largely German activities in Civil (small engines) as well as in France for Nuclear. The NOK impact is in Marine. The group provides a good degree of details on that sensitivity (1 cent is GBP3m of PBT for the USD and GBP2m for the EUR for instance). Figure 13: Average spot rates for GBP vs USD and EUR E 2018E 2019E 2020E Average GBP/USD rate Average GBP/EUR rate Source: Company data, Credit Suisse estimates Extracting the transaction and translation impact from PBIT and FCF The FX impact reported by Rolls-Royce only covers the translation part, with the transaction impact accounted for in underlying numbers but not disclosed per se. Based on our estimates, the cumulative 2017E-2020E transactional benefit comes to c.340m, accounting for nearly half of the earnings progression which we calculate at group level (and c.55% for the Civil Aerospace business). Based on our calculation, the FX benefit (resulting from the transaction + translation impact on PBIT) on cash-flow between 2016 and 2020E comes to GBP380m, or 40% of the improvement in FCF generation (from GBP100m in 2016 to GBP1,046m in 2020E). Rolls-Royce (RR.L) 13

14 Figure 14: Estimated FX impact on PBIT in GBPm pre-ifrs E 2018E 2019E 2020E Civil Aerospace Change in GBPm o/w Translation o/w Transaction Change excluding FX Defence Aerospace Change in GBPm o/w Translation o/w Transaction Change excluding FX Power Systems Change in GBPm o/w Translation o/w Transaction Change excluding FX Marine Change in GBPm o/w Translation o/w Transaction Change excluding FX Nuclear Change in GBPm o/w Translation o/w Transaction Change excluding FX Total 1, ,189 1,419 1,643 Change in GBPm o/w Translation o/w Transaction Change excluding FX Source: Credit Suisse estimates Rolls-Royce (RR.L) 14

15 Figure 15: Divisional data pre-ifrs15 in GBPm E 2018E 2019E 2020E FX rates GBP/USD - spot GBP/USD - hedges Engine deliveries Large engines Small engines Revenues - underlying Civil Aerospace 4,919 5,572 6,437 6,655 6,837 6,933 7,067 8,018 8,555 9,001 9,496 Defence Aerospace 2,123 2,235 2,417 2,591 2,069 2,035 2,209 2,281 2,230 2,213 2,226 Power Systems ,831 2,720 2,385 2,655 2,839 2,871 3,037 3,261 Marine 2,591 2,271 2,249 2,527 1,709 1,324 1, ,094 1,203 Nuclear 1,233 1, ,048 1, Eliminations Total group 10,866 11,277 12,209 15,505 14,588 13,354 13,783 14,901 15,394 16,195 17,101 Operating profit - underlying Civil Aerospace Defence Aerospace Power Systems Marine Nuclear Intra-segment Holding + Others Total group 1,010 1,206 1,495 1,831 1,681 1, ,189 1,419 1,643 Operating margin (%) Civil Aerospace 8.0% 9.0% 11.5% 12.7% 13.8% 11.7% 5.2% 6.1% 7.2% 8.8% 10.2% Defence Aerospace 14.6% 16.8% 16.3% 16.9% 17.7% 19.3% 17.4% 15.9% 16.2% 16.4% 16.5% Power Systems 24.2% 38.0% 10.4% 9.3% 8.1% 7.2% 7.3% 7.6% 8.0% 8.5% Marine 12.8% 12.6% 13.1% 9.2% 8.1% 1.1% -2.4% -3.7% 1.4% 3.3% 3.9% Nuclear 2.2% 1.5% 2.0% 7.1% 3.6% 10.2% 5.8% 2.9% 3.4% 3.4% 3.3% Total group 9.3% 10.7% 12.2% 11.8% 11.5% 11.2% 6.6% 6.7% 7.7% 8.8% 9.6% Source: Company data, Credit Suisse estimates Rolls-Royce (RR.L) 15

16 Companies Mentioned (Price as of 05-Apr-2017) Airbus Group (AIR.PA, 71.82) Boeing (BA.N, $178.7) Rolls-Royce (RR.L, 766.5p, UNDERPERFORM, TP 665.0p) Safran (SAF.PA, 70.56) Disclosure Appendix Analyst Certification I, Olivier Brochet, certify that (1) the views expressed in this report accurately reflect my personal views about all of the subject companies and securities and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. 3-Year Price and Rating History for Airbus Group (AIR.PA) AIR.PA Closing Price Target Price Date ( ) ( ) Rating 18-Nov U * 16-Feb O 12-Mar Sep Oct Jun Jul Mar * Asterisk signifies initiation or assumption of coverage U N D ERPERFO RM O U T PERFO RM Target Price Closing Price AIR.PA Jan Jul Jan Jul Jan Year Price and Rating History for Boeing (BA.N) BA.N Closing Price Target Price Date (US$) (US$) Rating 14-Apr O 23-Oct N 28-Jan Jul Dec Jan May Oct Jan * Asterisk signifies initiation or assumption of coverage O U T PERFO RM N EU T RA L Target Price Closing Price BA.N 01- Jan Jan Jan Year Price and Rating History for Rolls-Royce (RR.L) RR.L Closing Price Target Price Date (p) (p) Rating 18-Nov U * 18-Feb Aug N 13-Nov Apr U 01-Jul Jul Sep * Asterisk signifies initiation or assumption of coverage. 1, U N D ERPERFO RM N EU T RA L Target Price Closing Price RR.L Jan Jul Jan Jul Jan Rolls-Royce (RR.L) 16

17 3-Year Price and Rating History for Safran (SAF.PA) SAF.PA Closing Price Target Price Date ( ) ( ) Rating 18-Nov O * 25-Feb Jul Oct Mar Jun Jan N 24-Feb * Asterisk signifies initiation or assumption of coverage O U T PERFO RM N EU T RA L Target Price Closing Price SAF.PA Jan Jul Jan Jul Jan The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts stock rating are defined as follows: Outperform (O) : The stock s total return is expected to outperform the relevant benchmark* over the next 12 months. Neutral (N) : The stock s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stock s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-japan Asia stocks, ratings are based on a stock s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock s absolute total return potential to its current share price and (2) the relative attractiveness of a stock s total return potential within an analyst s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Not Rated (NR) : Credit Suisse Equity Research does not have an investment rating or view on the stock or any other securities related to the company at this time. Not Covered (NC) : Credit Suisse Equity Research does not provide ongoing coverage of the company or offer an investment rating or investment view on the equity security of the company or related products. Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. Analysts sector weightings are distinct from analysts stock ratings and are based on the analyst s expectations for the fundamentals and/or valuation of the sector* relative to the group s historic fundamentals and/or valuation: Overweight : The analyst s expectation for the sector s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst s expectation for the sector s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst s expectation for the sector s fundamentals and/or valuation is cautious over the next 12 months. *An analyst s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors. Credit Suisse's distribution of stock ratings (and banking clients) is: Global Ratings Distribution Rating Versus universe (%) Of which banking clients (%) Outperform/Buy* 45% (64% banking clients) Neutral/Hold* 39% (61% banking clients) Underperform/Sell* 14% (52% banking clients) Restricted 2% *For purposes of the NYSE and FINRA ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors. Important Global Disclosures Credit Suisse s research reports are made available to clients through our proprietary research portal on CS PLUS. 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18 the Firm, as well as legal and regulatory constraints. To access all of Credit Suisse s research that you are entitled to receive in the most timely manner, please contact your sales representative or go to Credit Suisse s policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: Credit Suisse does not provide any tax advice. Any statement herein regarding any US federal tax is not intended or written to be used, and cannot be used, by any taxpayer for the purposes of avoiding any penalties. Target Price and Rating Valuation Methodology and Risks: (12 months) for Rolls-Royce (RR.L) Method: We value Rolls-Royce at 665p per share using a SOTP based on our 2018E EBIT forecasts (pre-ifrs15 to maintain comparability with history). We adjust our numbers for capitalised R&D costs. We use samples of Aerospace, Defence, Marine, Energy and Mechanical cap goods stocks for each of the divisions. We use EV/EBIT for all but Marine and Nuclear & Energy, where we used EV/sales. We include cost benefits from the current operational review launched by the group's new management. Our Underperform rating reflects our sense that the current price level anticipates too much of the hoped for recovery in earnings and cash flow. Risk: A further drop in GBP would boost Rolls-Royce earnings. Acceleration of services revenues would increase volumes of profitable businesses. Stronger than expected cash-flows would be a significant positive. Increased order intake in Marine or Power Systems would boost the prospects of these branches. Conversely, a deterioration of the group's end markets would impact both TP and rating, as would the deferall of the FCF improvement (not to occur before 2019). A potential takeover bid on Rolls-Royce would require a premium to be paid, which would undermine our Underperform rating and our valuation of 665p. Please refer to the firm's disclosure website at for the definitions of abbreviations typically used in the target price method and risk sections. See the Companies Mentioned section for full company names The subject company (RR.L, BA.N, AIR.PA, SAF.PA) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (RR.L, SAF.PA) within the past 12 months. Credit Suisse provided non-investment banking services to the subject company (AIR.PA) within the past 12 months Credit Suisse has received investment banking related compensation from the subject company (RR.L, SAF.PA) within the past 12 months Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (RR.L, BA.N, AIR.PA, SAF.PA) within the next 3 months. Credit Suisse has received compensation for products and services other than investment banking services from the subject company (AIR.PA) within the past 12 months A member of the Credit Suisse Group is party to an agreement with, or may have provided services set out in sections A and B of Annex I of Directive 2014/65/EU of the European Parliament and Council ("MiFID Services") to, the subject issuer (RR.L, AIR.PA, SAF.PA) within the past 12 months. As of the end of the preceding month, Credit Suisse beneficially own 1% or more of a class of common equity securities of (RR.L). For date and time of production, dissemination and history of recommendation for the subject company(ies) featured in this report, disseminated within the past 12 months, please refer to the link: Important Regional Disclosures Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report. The analyst(s) involved in the preparation of this report may participate in events hosted by the subject company, including site visits. Credit Suisse does not accept or permit analysts to accept payment or reimbursement for travel expenses associated with these events. Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit The following disclosed European company/ies have estimates that comply with IFRS: (RR.L, AIR.PA). Credit Suisse has acted as lead manager or syndicate member in a public offering of securities for the subject company (BA.N) within the past 3 years. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. This research report is authored by: Credit Suisse International...Olivier Brochet To the extent this is a report authored in whole or in part by a non-u.s. analyst and is made available in the U.S., the following are important disclosures regarding any non-u.s. analyst contributors: The non-u.s. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-u.s. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the Rolls-Royce (RR.L) 18

19 FINRA 2241 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Credit Suisse International...Olivier Brochet Important disclosures regarding companies or other issuers that are the subject of this report are available on Credit Suisse s disclosure website at or by calling +1 (877) Rolls-Royce (RR.L) 19