Rolls-Royce (OTCPK:RYCEF) has frequently been cited within value circles as a long-term recovery play on a high-quality business with a competitive moat. But the stock has drastically underperformed and now lies near multi-year lows after yet another underwhelming quarter. More importantly, management failed to answer the key question – exactly how the company will fund itself for the long term, especially now its credit has been downgraded to non-investment grade by all three ratings agencies. My base case remains for a major rights issue sooner rather than later, in addition to the planned disposals, with existing equity holders likely to face dilution.

Not Much to Like about 1H20

Expectations were low coming into the 1H20 print, but headline numbers still disappointed – revenue fell ~24% year over year, driving a ~£1.7 billion operating loss. This largely reflected COVID-19-driven headwinds within commercial aerospace and excluded the impact of the unwinding of various FX hedges. Including one-offs, reported losses were significantly higher.

(Source: Investor Presentation)

The 2H guidance does not signal much of an improvement either – free cash flow is set to come in at £1 billion, which would imply full-year FCF of -£4 billion. But I suspect 2H results could also disappoint significantly, given it incorporates a somewhat optimistic assumption around a recovery in flying hours in 2020 at -55% YoY. Assuming £30 million = 1% impact disclosed previously holds true, this spells significant downside risk for the 2H P&L.

The biggest disappointment, for me, though, was the lack of a formal fundraising announcement. Instead, what we got was more commentary around the £1 billion cost-cutting target for FY 20, as well as >£2 billion of disposals to strengthen the balance sheet. The problem is that, even with these efforts, management is calling for net debt to hit £3.5 billion as at year-end (excluding leases). Management did also hint at “further actions under consideration,” which likely means a fundraising announcement (of some sort) in the upcoming quarters, in my view, given the aim is still to get back to a net cash position.

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(Source: Investor Presentation)

Restructure and Recover

Cost-saving efforts are going well in civil aerospace – the company achieved £350 million of mitigations as of end-1H20 and is targeting a further £650 million in 2H. Thus far, headcount is down by 4,000, with another 1,000 in job reductions set for year-end. Looking out to FY22, total job cuts are set to hit >9,000 in total, with restructuring costs set to be implemented in three phases – £400 million in FY 20, £300 million in FY 21, and £100 million in FY 22.

(Source: Investor Presentation)

Management is also looking to reduce the overall capital intensity to ~3-4%, primarily by consolidating its manufacturing footprint. For instance, wide-body engine assembly is set to be consolidated into one site in Derby (from three prior), with management also looking to increase outsourcing to boost margins and overall returns.

(Source: Investor Presentation)

Given Rolls-Royce’s positioning, the recovery of large engine flight hours should outpace international revenue passenger kilometers (RPKs), although management guidance for a swift recovery could prove a touch optimistic. Freight and domestic represents a smaller share of flying hours relative to international, and thus, I expect a more gradual recovery toward ~70 to 80% of pre-pandemic levels in FY 22.

The ‘Severe but Plausible’ Downside Case is Becoming the Base Case

As part of the 1H20 release, the following quote stuck out:

The inherent uncertainty over the severity, extent, and duration of the disruption caused by the COVID-19 pandemic and therefore the timing of recovery of commercial aviation to pre-crisis levels and the availability of sufficient funding, represent material uncertainties that may cast significant doubt on the Group’s ability to continue as a going concern.

Yet, there was no fundraising announcement. Instead, the focus was on the >£2 billion of disposals, including ITP (its Spanish subsidiary), which seems optimistic relative to the prior £1 billion expectation. The updated number likely includes additional internal production assets as well, which highlights the sheer size of the balance sheet repair needed.

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(Source: Investor Presentation)

Even if we were to ignore the big £1 billion FCF outflow projected for 2H, the downward revision for expected FY 2022 FCF to £750 million (vs. “at least” £750 million in the July disclosure) is concerning. Given that the underlying assumption is for a very optimistic recovery to 90% of pre-pandemic levels by the back half of FY 22, the downside risk to these numbers is significant, in my view.

(Source: Press Release)

I am concerned that management is taking a wait-and-see approach to a rapidly declining financial situation when the better option would have likely been to bite the bullet and raise funds. With little sign of a swift recovery materializing, the “severe but plausible” downside scenario (where the company would need to tap into its revolving credit line) looks increasingly like the base case.

Insiders and Activists Have Deserted the Ship

Alongside the 1H20 results, CFO Stephen Daintith will also be leaving after three years at Rolls-Royce. CFO departures are generally a bearish signal, but when they come amid a major restructure, investors should take notice. This follows the departure of ValueAct (Rolls-Royce’s previous largest shareholder) last month when the group sold its remaining stake, having begun selling down its stake in 2019.

The timing of these red flags is uncanny – if Rolls-Royce’s CFO and (formerly) largest shareholder are selling at a time when management is calling for a swift recovery to pre-pandemic levels, what does it say about the actual state of affairs at Rolls-Royce? Either way, there is just far too much uncertainty here for investors to bottom fish, in my view.

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Cheap for a Reason

Rolls-Royce stock has underperformed materially year-to-date, with the earnings multiple now in the single digits relative to FY22 numbers. That seems cheap, but investors would do well to exercise caution. For one, the balance sheet is in dire straits – excluding leases, net debt is set to hit £3.5 billion in FY 20 (vs. the net cash target). With cash outflows set to continue into FY 21, and credit well below investment grade as well, that likely means more debt – or shareholder dilution. In my view, the stock is a firm pass. Additional risks include further macro/COVID-19 headwinds, a weaker defense spending environment, and a more gradual aerospace recovery.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.