Cube Midcap Report (1 Oct 2020) – Rolls refuels

Cube Midcap Report (1 Oct 2020) – Rolls refuels

Good morning!

There are three announcements of interest today:

  • Rolls-Royce
  • Smith & Nephew
  • Burford

Rolls-Royce

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Market cap £2.3 billion
RNS Proposed recapitalisation
Writer disclosure No position.

It’s no secret that Rolls is one of the major corporate casualties of the Corid disaster.

Shares were trading in excess of 600p last February.

In May, it announced a workforce reduction of 9,000 (out of 52,000 in total) and major capex cuts, mostly hitting its Civil Aerospace business. This was the largest restructuring in the history of Rolls-Royce.

Today, it announces the details of its financial reorganisation plans:

  • 10 for 3 rights issue to raise £2 billion
  • bond offering to raise £1 billion

Other developments are that a £1.9 billion liquidity facility will be replaced by a £1 billion term loan. And finally, with the help of UK Export Finance, another existing loan will be increased by £1 billion. These other developments seem less important, as they don’t result in a large net change in liquidity.

The rights issue is the most eye-catching part. 10 for 3! That’s a lot of dilution.

10 new shares are offered for every 3, i.e. 6.4 billion new shares being offered (the existing share count is only 1.9 billion). So the share count will balloon to 8.4 billion.

And despite the massive dilution, only £2 billion will be raised because the rights issue is priced at 32 pence.

That’s a 41% discount to the “theoretical ex-rights price”, which is 54.6p. A savage discount, forcing shareholders to take part.

Outlook

Rolls-Royce shareholders are asked to wait until 2022, before strong cash generation will again be seen. Target free cash flow in that year is £750 million.

Long-term prospects are still said to be strong:

In Civil Aerospace, we do not expect a similar level of investment as we move forward, given the majority of the development of our current programmes is complete. We expect our relatively young installed base of engines will provide strong, annuity-style cash flows over the long term, reflecting the long in-service lives of our products and our services-oriented business model. We see good growth opportunities in both Defence and Power Systems. Over the longer-term, our capabilities leave us well positioned to capitalise on the transition to sustainable, low-carbon power.

The major uncertainty is around “the timing and shape of recovery from COVID-19, notably with regards to long-haul air travel“. Naturally!

In the short-term, the free cash outflow this year is expected to come in at an incredible £4 billion.

My view

Guidance at the interim results (published in late August) suggested that FY 2020 net debt would be £3.5 billion.

The £2 billion equity infusion will certainly help to take out much of the financial risk, still leaving c. £1.5 bilion of net debt (all else being equal).

Given the £750 million annual free cash flow target from 2022 (with positive free cash flow beginning in late 2021), it can be argued that this proposed recapitalisation puts it back on a stable footing.

How to think about the current shares? Some back-of-the-envelope thoughts:

[3 Oct: updated this after a correction by a reader – thank you.]

The current share price is 118p. If you buy 3 of these (354p), you can then buy another ten for 32p each (320p). So for a total investment of 674p, you can buy 13 shares in the new company. That’s about 52p each.

The new company has 8.4 billion shares, i.e. a market cap of £4.4 billion.

Net debt might end the year at c. £1.5 billion, so the enterprise value is £5.9 billion.

That’s a multiple of around 8x the 2022 free cash flow target of £750 million. And the debt load could be higher in the short-term, depending on the current cash burn.

In summary, I think the current share price is cheap-ish, if the 2022 target is hit and the company can start deleveraging before too long. After the correction by the reader, which increased the prospective cash flow multiple from 6.5x to 8x or above, you do need some additional optimism.

The plan from Rolls states (and I’ve added the bold):

The targeted return of FCF of at least £750m (excluding disposals) as early as 2022 includes the expected impact of temporary outflows in that year, including approximately £300m of foreign exchange cash costs relating to our decision to reduce the size of the Group’s hedge book.

We expect our target FCF of at least £750m (excluding disposals) described above to continue to grow in the future, as the temporary negative outflows relating to the reduction in the Group’s hedge book and ongoing Trent 1000 costs unwind over time. This expected FCF growth after 2022 is expected to lead to continued deleveraging. In addition, our underlying businesses are expected to deliver growth.

If you can believe this, then I still think the shares are cheap-ish,  as the implication is that annual free cash flow can recover to £1 billion+. But you would probably need some patience and be willing to look forward to 2023 and beyond, for major results to be delivered in terms of this cash flow result and the resumption of significant dividends.

 


Smith & Nephew

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Market cap £13.5 billion
RNS Trading Statement
Writer disclosure No position.

This large medical devices group says that Q3 underlying revenue will decline by c. 4%.

That represents a brilliant bounce back from a disastrous Q2. I’m very pleased to see elective surgeries coming back:

All three franchises showed significant recovery following an overall underlying revenue decline of -29.3% for the second quarter. The improvement was strongest in our Orthopaedics franchise, as global levels of elective surgery continued to recover.

This is a lovely company that I wouldn’t mind owning a few shares in.

EPS is forecast to take a hit this year, but then return to 101c in 2021 and 112c in 2022. So the earnings multiple is around 18x, if you’re willing to look forward two years. Not a crazy valuation for a company with this track record.

 


Burford

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Market cap £1,560 million
RNS Interim Results
Writer disclosure No position.

This most unusual of companies provides another set of strangely-defined metrics.

  • Burford-only realisations” up 40% to $478 million.
  • Burford-only cash generation” up 35% to $486 million (this includes cash AND net receivables generated, even though receivables aren’t cash).
  • Burford-only realised gains from capital provision-direct assets” up 57% to $183 million. Surely there was a simpler way of saying this?
  • cumulative recoveries from capital provision-direct assets on Burford’s balance sheet” up 24% to $1.6 billion.

I’m increasingly turned off by this company’s use (abuse?) of the English language. When I read this stuff from a law firm, I can’t avoid the suspicion that I’m being lied to or misled, even if I’m not sure exactly how.

Despite the wonderful four metrics shown above, “Burford-only total income” was down 12% to $253 million, and “Burford-only adjusted operating profit” was down 14%. New business declined.

Thanks to an unfavourable tax charge, “Burford-only adjusted profit after tax” was down 29%, but the company didn’t see fit to print that percentage amount. It’s funny how percentage amounts are only printed when they aren’t too mortifying.

Separately, Burford has been registered at the SEC, and will start trading on the New York Stock Exchange around 19 October. This should help to boost the rating, given the state of US markets (but note that this may be partially or fully priced in already, especially after today’s 15% rally).

My view – despite my scepticism, I don’t consider the valuation here to be outrageous. Even since the bear raid, it has been priced at a level which at least shows some relationship with NAV ($1.5 billion as of last December).

 


 

That will do it for today, thanks for dropping by!

Graham

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    Thanks for a way to think about the Rolls valuation.

    The multiple for RR is more like 10.2 times given that there will be 8.3m shares after the rights issue. With additional debt likely, the multiple could be even higher so not so cheap even if £750m FCF is delivered in 2022.

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