As the underlying business has recovered from the Covid-19 pandemic, shares in Rolls-Royce (LSE:RR) have recovered strongly. And that raises an important question about dividends.
The firm’s said it won’t distribute cash to shareholders until it recovers its investment-grade credit rating. But after an upgrade from S&P Global, that might well be on the cards for this year.
Credit ratings
Despite Rolls-Royce having net debt 56% higher than in 2019, S&P Global upgraded the firm’s credit rating from ‘BBB-’ to ‘BBB+’ earlier this month. That puts the business in investment-grade territory.
Moody’s and Fitch have also upgraded Rolls-Royce bonds recently. Moody’s rated the company’s debt ‘Baa1’ and Fitch classified it as ‘BB+’.
Importantly, neither of these is an investment-grade rating – both are one tier below. But aggressive cost-cutting and resurgent demand for travel have put the business in a strong position.
I think the question is therefore ‘when’ Rolls-Royce gets upgraded by Moody’s and Fitch, rather than ‘if’. And I wouldn’t be at all surprised to see it happen in the next few months.
Balance sheet
As said, Rolls-Royce has more net debt on its balance sheet than it did in 2019. But two metrics indicate strongly to me that the business is in a better position to deal with that debt.
One is the amount of the company’s operating income it spends on interest payments on its debt. The other is how much debt the firm has relative to its cash earnings, or EBITDA.
In both cases, Rolls-Royce looks like it’s in a decent position. Interest expense might be higher than it was, but it currently accounts for 24% of operating income – which was negative in 2019.
Equally, before the pandemic, EBITDA was around 2.25 times net debt (which seems about right to me). But last year, £3.6bn in cash earnings comfortably covered just under £2bn in debt.
Should shareholders hope for a dividend?
Waiting for its credit rating to improve before declaring a dividend is probably wise. This should allow Rolls-Royce to refinance its debt at a lower rate, reducing interest expense and boosting profits.
Whether or not this is the best use of capital might be questionable. Despite its debt, the stock market currently values the stock at around 1.27 times the firm’s tangible assets.
If that continues, then keeping an extra £1 per share on its balance sheet should cause the Rolls-Royce share price to rise by £1.27. And that would potentially be a greater benefit to shareholders.
Paying out £1 per share from the company’s cash as a dividend would mean shareholders receive £1. Keeping it on the balance sheet at today’s multiples would allow them to sell it for £1.27.
Dividends ahoy?
I think it’s likely Rolls-Royce will get back to paying a dividend this year. I’m expecting further upgrades to the company’s credit rating and payments to shareholders to follow from there.
I’m not altogether sure this is something investors should welcome though. But it’s not up to me, so if I’m right about distributions being imminent, shareholders might as well enjoy them!
The post Why I think Rolls-Royce shares will pay a dividend in 2024 appeared first on The Motley Fool UK.
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Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has recommended Rolls-Royce Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
