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ROLLS-ROYCE ONWARDS AND UPWARDS By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

rollslog13 Feb 15. 2014 was undoubtedly a very challenging year for Rolls-Royce and while the current year will likely be little better I can say that, having attended the analyst meeting in London this morning, I have been left in no doubt that management is not only on top of the situation but also that this fine company continues to have excellent medium and long term growth potential.

While the order book, excluding the now divested Energy business ended 2014 at a record £73.7bn the company reported declines in revenue, profits and free cash flow. None of this surprised as the company had provided more than sufficient guidance in respect of certain issues outside of the primary civil aerospace business that would cause financial performance to be below that of 2013. It is worth reminding here that Rolls-Royce management had previously given warning that group revenue, profits and earnings would be likely to fall further in 2015.

Having listened and met with various senior Rolls-Royce management this morning I am satisfied that the company is adopting the right course of action to resolve various issues it has been faced with. It is only recently that I was forced to express a degree of concern over the handling of a second profits warning in late October last year and that reduced 2015 guidance further. I am however content to believe that, Forex and geo-political issues apart, we should not anticipate further profit warnings in the current year.

Of greater importance is that I am content to believe that management has finally understood the need for better communications. Being quite blunt and having followed and supported the company as an analyst through thick and thin right from the mid 1980’s standing up for it against the herd instinct when, under the excellent management of Francis Tombs and Ralph Robins, the company was struggling to be heard as it invested heavily to increase market share of wide bodied engines beyond the 10% level it then held I suppose that if I had one criticism it was the complete inability of some members of the management team to be able to communicate with large shareholders. Now, after all that time and large amounts of stress, I can at least say that I really do believe that the company understands the importance of good communication with shareholders.

To that end we have in the new Group Chief Financial Officer David Smith, a man who I have known through his many years at Jaguar Land Rover, someone who I believe will connect with the ‘city’ very well. The whole manner in which these preliminary figures were presented in terms of detail and breakdown and in particular the change made in terms of breaking down guidance is enough to show that the company has listened to criticism and got the message. I would also have to say that specific comments made by CEO John Rishton in his opening remarks confirmed this view and have left me in no doubt whatsoever that management fully recognise the need to better communicate.

Of course, important that communication is the bottom line is performance. In terms of operational performance improvement the concentration remains on the four ‘C’s Customer, Concentration, Cost and Cash. Read that as improving quality, delivery, reliability and responsiveness at one end of the scale and greater efficiency of operation at the other. Civil engine product takes years to develop and building market share even longer. It is hard to think now that RR only had a 10% world market share in wide bodied civil engines back in the mid 1980’s but that today that figure is over 50%. And that is the real point about Rolls-Royce – the value of the company remains today as it always did in the installed base of engines.

Research and development activity which comes under the jurisdiction of long time Rolls-Royce hand Colin Smith remains a key component of Rolls-Royce current and ongoing success. Last year the net R&D spend increased to £819 million reflecting increased spend on the higher thrust Trent XWB-97k which is due to enter service in 2017 and also on the Trent 1000-Ten which is die to enter service next year. The company is also investing in R&D for its Advance and UltraFan programmes which it believes will create large opportunities for the next generation of gas turbine engines.

With few short or medium term concerns as the company gears up to produce engines for the latest wide-bodied jet, the Airbus A350 XWB and also for those customers using its engines on the Boeing 787 Dreamliner I have few short or medium concerns on civil aerospace. That demand for Trent 700 engines may decline and Trent 900 level off is widely expected. But with the new generation of jets seeing very high order levels the future for RR in wide-bodied engines looks very secure. All credit to Tony Wood, President of the Aerospace division for achieving that. Given that even before the new additional capacity investment in the UK and in Singapore is running at full stretch civil aerospace which will remain the dominant area for Rolls-Royce looks to be in rude health.

With the sale of the Energy division to Siemens completed last year, the acquisition of the remaining 50% of Power Systems (Tognum) also completed last year I suspect that there will be little change in the portfolio over the coming year. Rolls-Royce Defence which is ably run by Tom Bell has done a remarkable job in making improvements across the division during some of the most difficult times seen in the division. The effort to reduce costs in the division and which has also for the first time in several years witnessed seen an increase in orders reflects strong determination to push the division forward on a lower cost base.

Power Systems is naturally more vulnerable to global market conditions and thus the short to medium term expectation is for lower demand. But as a long term business Power Systems looks to me to be a brilliant business and one that present superb opportunities. That leaves Marine which, due to a number of factors is unlikely to excite in the short to medium terms albeit that having closed nine facilities over the past few years and removed 1,000 personnel there will clearly be efficiency benefits, and nuclear which as far as I am concerned is an excellent business that Rolls-Royce commands universal respect.

With a strong balance sheet, decent free cash flow which although fell back sharply in 2014 and will likely fall further on the back of the ongoing £1bn share buyback and still high although reducing levels of capital; expenditure and research and development spend there are no real concerns on cash flow or balance sheet front.

I will leave it at that. A difficult year that in the end in terms of communications and operation has been well handled. This year will be another tough one for Rolls-Royce leaving aside the vagaries of Forex, Eurozone and Far East Asia growth and particularly issues that impact on China. A weak Russia is unhelpful too. Rolls-Royce is a big company, a great UK success story and an international success story as well. With annual revenue approaching £14bn and a determination to grow market share and improve shareholder performance management has got a big job to do. I for one am I no doubt that two years from now we will be viewing that success. The bottom line should be that on a five year performance basis Rolls-Royce has performed very well and it has rewarded its shareholders well.

hwheeldon@wheeldonstrategic.com

chwheeldon@yahoo.co.uk

Tel: 07710 779785

 

 

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