Rolls-Royce’s 2022 Benefits From Contract Discipline, Improved Operating Environment

Narrow-moat Rolls-Royce RR. reported higher 2022 revenue and operating profit than we forecast. The business benefited from a more favorable operating environment as well as tighter management of contractual terms and pricing. We maintain our GBX 105 fair value estimate. The company is working toward restoring its balance sheet and investment-grade rating. While not making it past that goalpost yet, Rolls-Royce was able to pay back GBP 2 billion in loans in 2022, leading to a net debt reduction to GBP 3.3 billion from GBP 5.2 billion. This debt reduction was possible due to positive free cash flow generation of GBP 505 million and more significantly EUR 1.8 billion in proceeds from the disposal of ITP Aero.

Free cash flow benefited from a rebound in aviation activity seen throughout the civil aerospace division. Divisional revenue grew 25% organically with positive price (spare parts pricing up double digits), operating leverage, and more-disciplined enforcement of contractual terms with customers. This led to a more than 400-basis-point year-over-year increase in divisional operating profit margin to 15%. The division books revenue with declines in its long-term service agreement balances, with greater aviation activity flowing into cash flow with shop visits across large engines, business aviation, and regional fleets. Shop visits for large engines grew 19% year over year. Large engines also saw 35% growth in large engine flying hours. Management expects shop visits to grow by 20% or more and engine flying hours to increase to 80%-90% of 2019 levels.

New CEO Tufan Erginbilgic has yet to set out specific targets for a turnaround strategy, including timing to get back to an investment-grade rating. However, on the conference call, he gave some hints that the focus will be less on asset disposal than on operational improvements.