Cube Midcap Report (28 Aug 2020) – Rolls Royce hits new lows
Good morning! It’s Roland here with the Midcap Report. Today I’m going to circle back to take a look at recent half-year results from Rolls-Royce Holdings and housebuilder Persimmon.
On a macro note, yesterday provided further evidence that interest rates are likely to stay lower for longer. US Federal Reserve chairman Jay Powell said that the Fed would no longer target an inflation rate of 2% (as the Bank of England also does). Instead, the US central bank will now allow inflation to overshoot to allow for previous periods of lower inflation.
The implication seems to be that even if inflation rises above 2%, the Fed will be very reluctant to increase interest rates. This is a partial reversal of its previous policy, which saw rates rise from 2015-2019, before being cut again.
With interest rates likely to remain low, I guess the hunt for yield could continue to support share prices despite the record highs seen in US markets. Interesting times.
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|RNS||Half-year report, CFO resigns|
|Writer disclosure||No position|
The Rolls-Royce share price has fallen by another 7% or so this week, thanks to a fairly dismal set of half-year results on Thursday. I have to admit I was a little surprised. I’d assumed the bad news would have been priced in after July’s H1 trading update, which Graham covered here. It seems things can always get worse.
A key departure in the boardroom may not have helped market sentiment: CFO Stephen Daintith is departing after four years to take up the same role at high-flying Ocado. Remarkably, Rolls’ 65% share price slump this year means that Mr Daintith is moving from the worst-performer in the FTSE 100 to this year’s top riser.
I don’t think there are any factors other than ambition at work here, but it might have been a little more reassuring if Mr Daintith had remained until a recovery was underway. Anyway. Let’s look at some figures.
H1 results summary
The headline figures are not encouraging:
- Revenue down by 26% to £5.8bn
- Operating loss of £1.8bn
- Pre-tax loss of £5.4bn
- Free cash outflow of £2.8bn
- Large engine flying hours down by 53%
- Large engine deliveries: 137 (H1 2019: 257)
There were some significant one-off costs:
- Hedging: Rolls reports in GBP but does most business in USD. To protect against exchange rate volatility the company maintains a big hedging book. This is being cut by $10.3bn to $26.2bn to reflect lower revenue forecasts. This will result in a £1.46bn financing charge.
- Write-offs and restructuring: The weak outlook for civil aviation prompted the firm to record impairment charges totalling £1.1bn and restructuring charges of £366m. These relate to physical assets and intangibles related to engine development programmes.
- £1.1bn cash outflow from cessation of invoice factoring: this reflects the company’s decision to stop using invoice factoring, which is essentially a hidden form of debt. I support this move as it should provide a cleaner and less leveraged balance sheet, going forward.
I believe [hope] that it’s correct to view the second-quarter as a low point for global flying hours. But the company’s forecasts suggest the recovery will be slow and gradual. Large engine deliveries are expected to average around 250 per year in 2020-2022, compared to 510 in 2019. Rolls was originally forecasting deliveries of 450 for 2020.
These numbers show the scale of the disruption that’s hitting this business. CEO Warren East is having to scale back the group’s capacity to have some hope of operating profitably. However, the group’s liquidity situation and cash flow guidance suggests to me there could be some value here.
Liquidity, net debt & disposals
Rolls Royce had total available liquidity of £8bn at the end of June. This figure is expected to fall to £6bn by the end of 2020. That may sound comfortable, but the group needs a strong balance sheet to retain its status as a primary supplier to airlines and aircraft manufacturers.
After this year’s cash outflows, net debt is now relatively elevated. Excluding lease liabilities, net debt was £1.7bn at the end of June. This compares with a net cash position of £1.4bn at the end of 2019.
To help strengthen its finances without needing an equity raise, Rolls plans to raise £2bn through divestments. The main target appears to be the ITP Aero business. This subsidiary makes engine parts for passenger jets and military aircraft including the Eurofighter Typhoon.
There’s still some risk that Rolls will need an equity raise to cut debt levels. But I don’t see any pressing need for this at the moment. Indeed, I suspect Mr East will be able to avoid this if the group can secure some cash from disposals.
Forward guidance: encouraging but uncertain
The company expects a £4bn free cash outflow in 2020, leaving the group with £6bn of liquidity and net debt (exc leases) of £3.5bn.
Free cash flow is expected to turn positive during the second half of 2021. In 2022, the company expects to generate positive free cash flow of £750m.
However, the outlook remains highly sensitive to large engine flying hours. This is an analog for the level of long-haul flying globally. Rolls Royce says that each 1% variance in large engine flying hours has a £30m impact on cash receipts.
Even without the impact of COVID-19, CEO Warren East was already facing a tough turnaround job at Rolls. With the pandemic added to the mix, it’s clear that the outlook remains highly uncertain.
However, I don’t think that’s necessarily a reason to abandon this stock. The company has significant market share and few competitors in the large jet engine market. Unless you believe long-haul flying is dead, I’d argue that a recovery is inevitable.
Rolls Royce’s financial situation does not seem especially stressed to me. Certainly it’s stronger than many large airlines.
If the company can deliver £750m of free cash flow as projected for 2022, that would give the stock a free cash flow yield of nearly 15% at current levels. Rolls shares are trading at post-2008 lows. I think they could offer value to patient investors from this level, although I don’t expect a quick fix.
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|Writer disclosure||No position|
Pent-up demand for housing has seen house prices and volumes rise since the market reopened. According to Nationwide’s House Price Index, prices rose by 1.7% in July.
Rightmove’s numbers suggest that August saw “the highest number of sales agreed in a month” for at least 10 years, with a record value of more than £37bn.
At the same time, government figures show that the UK is in the deepest recession since records began, with GDP down 20.4% during the three months to June.
How should we interpret these figures as potential housing investors? I can see two choices:
- Pent-up demand for housing will be short lived, the market is doomed
- The recession is a technical glitch caused by lockdown that will soon be erased
I have no idea which of these slightly flippant suggestions is correct. I suspect the truth lies somewhere in the middle. With the furlough scheme set to end and unemployment likely to rise, I find it hard to be too bullish. But there are sections of the population whose livelihoods haven’t been touched by the pandemic.
The Chancellor is doing his best to pimp the housing market with a Stamp Duty holiday. I suspect we’ll also get an extension to Help to Buy. We’ll have to wait a few more months to see whether the market momentum seen over the summer continues
In the meantime, let’s take a look at how FTSE 100 housebuilder Persimmon has traded during the first half.
Solid trading, dividend reinstated
Persimmon’s share price is now only 5% below the level at which it started the year. The firm’s half-year results suggest that the stock’s rapid recovery may not have been overdone.
Although completions fell by 35% to 4,900 during the first half of the year, the group’s average selling price actually rose by 3.7% to £225,066. Given the impact of lockdown, these numbers seem to suggest fairly resilient market conditions. Here are a few highlights:
- Revenue down 32% to £1,190m
- New housing gross margin 31.3% (H1 2019: 33.8%)
- Pre-tax profit down 43% to £292.4m
- Dividend: 40p per share (Full-year 2019: 235p)
- Net cash at 30 June: £828.9m (H1 2019: £832.8m)
- Land creditors: £374.5m (H1 2019: £435.2m)
- Forward sales: £2,483m (H1 2019: £2,048m)
I view land creditors as a form of debt, so I’d argue that true net cash is only £454m. But there’s no doubt these figures paint a fairly healthy picture, with strong forward demand.
The dividend has been cut from last year and consensus forecasts now suggest a figure of 110p for 2020, giving a 4.1% yield.
I’d suggest that the payout is unlikely to return to the 235p per share level enjoyed last year, which equates to a return of £750m. With a new CEO coming on board, I’d imagine that prudence and sustainable growth will be prioritised over up-front returns.
Persimmon’s profits aren’t bullet proof. My quick-and-dirty calculations suggest that a 5% fall in selling prices could result in a 20% drop in pre-tax profit. But Persimmon looks to be in good financial health at the moment and the firm’s performance during lockdown suggests to me it could withstand a slowdown in demand.
Are the shares cheap? Although the forecast yield of 4.1% for 2020 is appealing, the shares are trading at around 2.5 times book value. I can’t bring myself to believe this is cheap, even if the firm’s 26% operating margin does support a premium valuation.
I’d argue that sector valuations such as these are largely being sustained by government measures. Help to Buy has now been in place for so long that it’s tempting to believe it’s permanent. Personally, I can’t get comfortable with that view. Although I may miss out on some attractive returns, I’m not buying housebuilders at the moment.
That’s all I’ve got for today, thanks for reading.
As always we really appreciate any feedback and thumbs up (or down) to help shape future coverage.
Enjoy the bank holiday weekend.