Rolls-Royce: jet engine maker’s recovery is not plane sailing

Rolls-Royce is not flying a straight course. Boss Warren East must have hoped to reassure investors with news that the jet engine maker had stopped burning cash in the third quarter. But the new virus variant has overshadowed the improvement.

Omicron may set back a long hoped for recovery in international travel. Engine flying hours are currently half of 2019 levels. The potential effect of the variant is anyone’s guess, pending information about virulence and vaccine escape. But in the worst case, analysts think the airline sector’s recovery could be delayed by up to a year.

This matters because Rolls-Royce’s jet engine business makes most of its money from the flying time clocked up by engines. Its “power by the hour” business model, intended to align the interests of manufacturer and operator, normally provides a predictable revenue stream. Then Covid-19 hit.

A rule of thumb is that every 1 per cent drop in flying hours results in £30m less cash flow. The picture is complicated by other cash movements, the biggest of which relates to concessions. Engines are sold at full price to the aircraft maker. When the latter delivers to the final customer, Rolls-Royce has to fork out a pre-agreed discount. Around £300m of concession payments, originally expected in 2021, will now be due in 2022 as a result of delayed delivery of aircraft.

This year’s free cash outflow will therefore be smaller than the £2bn previously forecast. The flip side is that concession payments will weigh on next year’s free cash flow. Some analysts expect little better than a break even then.

Rolls-Royce is delivering on what it can control. It has cut costs faster than expected. It has announced some £2bn of disposals, putting net debt on course for 4.5 times ebitda by the end of the year. The aim is to secure an investment grade credit rating by 2024-25.

The performance of the shares reflects the uncertainty about the pace of recovery. They trade on a forward enterprise value-to-ebitda ratio of 10, a tenth above their ten-year average. But the buffeting from the pandemic is beginning to feel like a permanent phenomenon.