OREANDA-NEWS. November 17, 2015. Fitch Ratings has revised Rolls-Royce Holdings plc's (Rolls) Outlook to Negative from Stable while affirming its Long-term Issuer Default Rating (IDR) and senior unsecured rating at 'A'. This follows a further profit warning issued by the company on 12 November 2015.

The Outlook change reflects our view that Rolls' key financial metrics, such as free cash flow (FCF) and gross leverage, may no longer be commensurate with the current ratings from 2016. Fitch believes that the financial profile of Rolls is likely to recover in the medium- to long-term as a consequence of restructuring measures improving the group's cost structure as well as stabilisation in some key end-markets. However, should the recovery stall or take longer-than-expected, leading to a prolonged period of weak cash generation, a downgrade is likely.

KEY RATING DRIVERS
Deteriorating Financial Metrics
While earnings and cash flows in 2015 will be somewhat lower than in 2014, 2016 will see a material deterioration in these measures as a consequence of slower markets for maintenance and spare parts relating to the existing fleet of large aero engines, weak demand for corporate and business jet engines as well as further deterioration in the marine division.

Restructuring measures are likely to aid the recovery of key metrics over the medium term, but the ratings will face pressure if the company's FCF generation does not return to historical levels from around 2018, in line with our expectations of the company exiting the costly ramp up and programme transition phase of the product life cycle.

Gross Debt Increase
We expect the October 2015 USD1.5bn bond issue to lift gross adjusted debt to GBP4.6bn for 2015, from GBP3.7bn in 2014. This bond issuance provides additional liquidity over the upcoming cash absorption period but stresses our expectations of funds from operations (FFO) gross adjusted leverage for 2015 to around 2.7x from 2.0x at end-2014. This is beyond our negative rating guideline of 2x until cash generation builds after the investment period. We do not expect the strained leverage metrics over the 2015-2017 period to be a long-term feature of the company's financial profile. Net leverage remains in line with our expectations for the rating level.

Resilient Business Profile
Rolls has demonstrated the ability to manage a broad portfolio of turbine-related assets and generate cash for several years despite industry challenges and wider economic pressures. The company is well placed to withstand potential declines in demand resulting from deteriorating market conditions, due to its business diversification, growing proportion of long-term service contracts, and cost-cutting measures.

Suspended Share Buyback Supportive
The suspension of the GBP1bn share buyback programme after purchasing only GBP500m of shares provides some additional headroom to maintain the company's financial metrics as it enters a period of cash- absorbing programme launches and growth. In particular, the savings help fund some of the lost earnings resulting from reductions in Trent 700 build rates over the next three years. The buyback was funded with proceeds from the GBP985m sale of the energy gas turbine and compressor business to Siemens AG in December 2014.

Commercial Aerospace Outlook Positive
Rolls derives about half its turnover from the commercial aerospace industry, where the outlook for engine deliveries and service work remains positive. The production of large commercial aircraft - and the engines the company manufactures for them - is set to increase in the short- to medium-term, reflecting the strength and quality of the order book.

KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Rolls include the following:
- Approximately flat revenue in the short- to medium-term.
- A slightly reduced FFO margin in 2015 due to marine weakness, low profitability on deliveries of newly launched programmes. Cost reductions to partially offset pressure on earnings over the coming two to three years.
- Capex to fall to 7% of revenue due to lower development work in the pipeline.
- 25% reduction in dividend payment in 2016.
- Share buyback to cease at GBP500m.

RATING SENSITIVITIES
Negative: Future developments that may, individually or collectively, lead to negative rating action include the following.
- Lease-adjusted debt/FFO ratio of sustained higher than 2x (2014: 2x, 2015E: 2.7x).
- FFO/revenue ratio of less than 11% over a sustained period (2014:12.2%, 2015E: 10.9%).
- FCF margin consistently under 3% (2014: -2.6%, 2015E: -2.7%).
- Fixed charge cover of under 7x (2014: 7.8x, 2015E: 7.4x).

An upgrade is unlikely in the absence of a material change to the group's business profile, given that the company has reached a rating close to the highest Fitch deems achievable for the aerospace and defence industry.

LIQUIDITY
At end-1H14 Rolls had committed long-term banking facilities totalling GBP1.5bn and GBP587m of cash and short-term deposits (net of a GBP1bn adjustment for intra-year operational cash requirements). A USD1.5bn bond was issued in October 2015. This compares with short-term borrowings of GBP267m. Rolls-Royce has a back-ended debt maturity profile and sound access to capital markets.