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Rolls-Royce – Onwards and Upwards By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

No one is going to deny that for a company to report a headline loss of £4.6 billion caused by the impact of a mark-to-market hedging revaluation that has been required due to a huge drop in the value of sterling through 2016 together with a need to provide £671 million in relation to the Deferred Prosecution Agreement covering ultimate cash settlement to UK, US and Brazilian authorities following the Leveson judgement is anything other than hugely disappointing.

To say that 2016 was not a very good year for Rolls-Royce would be a serious understatement on my part and it would wrongly downplay the unfortunate plight that Rolls-Royce has found itself in. Naturally, there will be huge concentration played out on the headline results by press and media today but for all that, there are at least some small signs of progress emerging from the concentrated effort that RR management, under Warren East, are putting in to ensure that Rolls-Royce really does have a brilliant future.

From a bottom line perspective underlying revenue was down 2% and underlying profit, at constant exchange rates, was down 49%. But while good news may be hard to find within the actual FY16 results look hard and look deep and real signs of transformation policy progress can be found as the company continues what will clearly be a three process of change and making itself more efficient and competitive.

Importantly, CEO Warren East has significantly strengthened his top team over the past year whilst at the same time addressing the very top-heavy structure that he found when he joined the company in July 2015. Other positive points to note within the FY16 statement include confirmation that the company is now on-track to achieve an incremental in-year cost savings run rate of circa £200 million by the end of 2017. For the record, net debt was £225 million at year end, total equity stood at £1.86bn down from £5 billion and free cash flow achieved during the year was £100 million. An important point to note is that the company does not expect to make any material net additions to the hedge book in 2017.

I have previously written on the Deferred Prosecution Agreement and do not propose to add more than a couple of short paragraphs on the subject here. That huge mistakes were made by Rolls-Royce over a number of years has not been denied and neither has there been any misunderstanding that whatever occurred was unworthy of everything that Rolls-Royce had long stood for. What is done is done though and I take the view that in the manner that the company has approached the criticisms levelled at it by Leveson, how it has accepted serious past misdemeanours, the need for change and in how it has already demonstrated that management will be ruthless in execution of a zero-tolerance policy in future are commendable.

We can I believe take heart from what Sir Brian Leveson also said in January when the Deferred Prosecution Agreement was announced “that Rolls-Royce is no longer the company that once it was; its new Board and executive team has embraced the need to make essential change and has deliberately sought to clear out all the disreputable practices that have gone before, creating new policies, practices and cultures”.

The focus now is on pace and simplicity, strengthening focus on engineering and operational excellence and leveraging the installed base. The next stages may be best described as delivering results from the start of the transformation programme, continue to show progress from the embedding of operational excellence improvements and in rebuilding trust and confidence in long term growth prospects.

Due to time and heavy broadcast requirements today I do not propose to talk in detail on divisional performance except to suggest that the FY17 outlook provided by the company on civil engines appears reasonable if mixed, power systems steady, nuclear positive, defence steady in terms of revenue outlook although there is some pressure on margins and marine remains cautious although there should be some benefits from cost cutting. Research and development spending is likely to be around £800 million this year and free cash flow similar to FY16.

I am always at pains to stress that even with strengthened management team turning Rolls-Royce around and putting it back on the path to prosperity would require three to four years. I have not changed my opinion. Notwithstanding other difficulties that will need to be faced including the impact of IRFS 15 next year, the road ahead for the company, its shareholders and workers is in my view moving ahead in a positive direction.

Another necessary and initially negative change that comes into force in January next year will be the new IFRS 15 accounting standard that requires all companies to recognise revenues once a customer obtains control over the specific goods – meaning I suppose once these are delivered to the customer or that the customer assumes control over them.

While most companies operate such policies automatically, due to the nature of their business and revenue and profit benefits being immediate as opposed to being protracted through the lifetime, as in the case of an aero engine lifecycle for instance, Rolls-Royce has long had a policy of accounting for revenue through the long product lifetime. The company had warned last year that while the ‘net present value’ of the business would not change, IFRS 15 would initially have a negative impact on reporting and so it will.

In detail, the change in accounting practice is an attempt by the International Accounting Standards Board to make it more difficult for firms to accelerate or delay revenues.  In the case of Rolls-Royce however the reality behind the change is that while the company might typically produce a loss on the manufacture and sale of a new large commercial aero engine it produced, it would later profit through many years of MRO (Maintenance, Repair and Overhaul) activity. The new accounting standard will make reporting of figures more actual and transparent and forces the company to recognise the manufacturing loss immediately as opposed to compensating for this by taking in MRO service based revenue that it has hitherto done through its ‘Total Care’ programme for airline customers.

While the new reporting standard will make it easier for analysts to view the company it means that profitability in terms of how it is reported could be hurt for several years through the period of transition impact. Eventually, when the transition period which may be presumed for the purposes of this exercise to be through the first one-third period of an engine lifecycle before MRO activity increases, not only will profit/loss visibility have greater clarity but profits should increase incrementally. That position however may be some years off yet. Nevertheless, it is important to remember that this is a long term business in which profitability comes primarily through incremental revenue – in other words through the final two thirds of an aero engine lifecycle. The ends justify the means and eventually investors should be better off for the change in accounting standards.

I have tried in the above comments to be open and frank about the difficulties the company faces. I am as disappointed as the rest and yet I remain optimistic that the objectives Warren East has set will all be achieved and that Rolls-Royce will prosper as a result. A significant amount of time will be required before all the objectives are met and yet somehow, even though I am well aware that the road ahead will have more than a few bumps, I have no doubts at all about the ability of management to achieve what they have set out to do.

I will leave the last word to Warren East who said in the statement today “As I set out in November last year, it is now time to look further ahead. With my new team in place, our focus is turning the Group’s long term goals. Over the next few months we will conclude our review of strengths and investment opportunities and set out an appropriate vision for the business and the best way we can deliver sustainable shareholder value”.

CHW (London – 14th February 2017)

Howard Wheeldon FRAeS

Wheeldon Strategic Advisory Ltd,

M: +44 7710 779785

Skype: chwheeldon

hwheeldon@wheeldonstrategic.com

@AirSeaRescue

 

 

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