OREANDA-NEWS. Fitch Ratings says that maintenance, repair and overhaul (MRO) remains a supportive factor for aerospace and defence (A&D) companies' ratings due to the diversification and higher margins it provides, and generally less cyclical cash flows. In particular, we believe that the 2016 earnings revision recently announced by Rolls-Royce PLC (A/Stable) partly caused by lower service work at the commercial aerospace division is company-specific and represents an aberration in the A&D sector.

Service work, including MRO and spare parts, serves as a complementary function to the manufacturing process and typically accounts for less than 25% of an A&D company's turnover. It is less capital-intensive and often generates higher operating margins than the sale of equipment, which is sometimes sold at a loss if accompanied by a long-term service contract.

Furthermore, service-generated revenue tends to be far less lumpy than equipment sales and, depending on the size of the product order book, provides better revenue visibility. This is especially true in commercial aerospace, where strong global growth in airline traffic and fleets in recent years, expected to continue in the short- to medium-term, serves as a good guide to the amount of service work required.

Rolls-Royce recently announced a GBP650m revision to the company's expected earnings in 2016 (or over 30% of 2015 expected earnings), partly the result of a sharp decline in the aerospace division, stemming from lower maintenance and servicing work. The company generates around half of its turnover from commercial aerospace (and around half of that from MRO activities). The impact on servicing cash flows will be far less pronounced than the impact on earnings announced due to a more aggressive recognition of servicing earnings than some others in the industry.

The company's projected earnings decline from service work derives chiefly from the currently outsized exposure to the T700 engine which currently represents 30% of the installed base of large civil engines. It is mostly used on older A330 large jets, whose usage has been curtailed by airlines more than expected owing to its worse fuel efficiency compared with aircraft with newer engines.

Over the coming years, we still expect the servicing element of the Trent 700's profit stream to remain by far the more stable component compared with original equipment, where production rates are dependent on Airbus' defined ramp down schedule and expected to finish entirely by 2019. However, it is not immune to volatility itself and is also dependent on intensity of usage.

Fitch believes that as Rolls-Royce transitions to the new T7000 engine on the A330neo jet in the coming three years, along with the broader reshaping of the installed engine base resulting from growth in the production of other engines, such as the Trent XWB on the A350, the problems relating to the T700 are likely to become less significant beyond 2016, and the company's MRO results are likely to return to a trajectory in line with that of the sector.