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Rolls-Royce – Rewarding Investor Patience, Restoring Confidence and Looking Forward to Year Ahead By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

 

 

 

 

On a day when global stock markets are a somewhat diffident mood in regard of difficulty in counting the potential cost of the coronavirus outbreak, supply chain issues and other factors that are already hitting companies in the electronics and other industries, it is good to see that Rolls-Royce shares had risen over 6% by lunchtime today on the back of much improved FY19 financial results performance combined with further improvements to be expected in the years ahead. 

While there is still some way to go yet before CEO Warren East and his excellent team including Chief Financial Officer, Stephen Daintith will be able to say that they have achieved all the aims that they had set, the FY19 results genuinely show that a radical improvement has taken place – one that from where I sit as a long time analyst of the company – is not only very rewarding to see after all the effort that has been put in so far but also looks to me to be very sustainable.

Combined with the anticipated reducing impact of the serious and costly Trent 1000 technical issue together with benefits yet to come from long term ongoing research and development in regard of various planned next generation commercial aircraft engines – those that will burn even less and more sustainable fuels in the future and many other important aspects in the period of climate change that we are all beginning to belatedly come to terms with in particular the need to reduce damage to the environmental, other important issues such as reducing cost of operation for airlines, further reducing engine noise, I take th4e view that Rolls-Royce is very well positioned to reap some very interesting rewards from the investments it has already made into next generation jet engines in the years ahead.

Add to this ongoing efforts to further improve productivity and competitiveness, more capital investment being placed into the business together of course, with working very hard in order to get the final numbers of Trent 1000 powered Boeing 787 aircraft that are currently still grounded back into the air very, I will stick my neck out and say that Rolls-Royce not only has an excellent outlook but also that form an investment perspective it has finally come out from the cold.      

Having set about a major restructuring of the organisation five years ago, one that has over subsequent years helped to improve margins, place Rolls-Royce in a better and more effective position of competitiveness against international peers and create consistent improvements in operating profit and earnings, it was both untimely and with great regret that the company was then hit with serious fan blade durability issues on the Trent 1000 – an extremely important version of the Trent family of engines and one that had been designed specifically for the Boeing 787 Dreamliner.

Not surprisingly, from the moment that the Trent 1000 fan blade durability issue surfaced Rolls-Royce has treated this as its number one priority. The plan put in place by Rolls-Royce involved a very detailed technical evaluation phase on materials and machining in order to find a permanent solution that would lead to the problem being properly resolved. Rolls-Royce was able to achieve a solution to the problem relatively quickly but producing the revised blade unit and getting it fitted and the aircraft back in the air could never be done overnight.

With the quality and durability issue having left so many Boeing787 aircraft grounded awaiting rectification by Rolls-Royce engineers it was very pleasing that last November the company had been able to confirm that detailed technical evaluation of the work that they themselves had done to improve the high-pressure turbine blade was now complete and that additional action to further expand maintenance capacity and increase the stock of spare engines was also under way.   

Back to the here and now of operational and financial performance. Delivering a record number 510 widebody commercial aero engines to aircraft manufacturers and having secured approximately two out of every three new orders for widebody engines pushing Rolls-Royce further ahead as the number one supplier of large commercial aircraft engines, CEO Warren East’s accompanying FY19 results message to analysts, investors, shareholders, press and media today was one that said “building on the strength of our performance into the end of 2019, we are looking forward to 2020 with some degree of conviction and confidence”.

These are to be considered as being very positive remarks from a highly respect CEO who set out on a huge task four years ago to modernise the company from bottom up, to improve efficiency across all areas of the business – defence and power systems along with commercial gas turbine aero engines – improve productivity and competitiveness, bring in better people, continue investing in the company’s own future through raised research and development expenditure where necessary and, as just one example, in next generation products such as UltraFan, to change the culture of the organisation along with internal thinking, and by doing the seemingly near impossible, creating an attitude throughout the company that implies everyone can do better. This is a company that is hell bent on improving performance and one that will never take no for an answer in the pursuit of achieving better results.

As part of a planned process put in place by Warren East following an operational review in 2015 Rolls-Royce has shed a great many middle management jobs. Such was the strength of argument and persistence; Rolls-Royce also moved its expensive head office away from Buckingham Gate to a much cheaper and convenient location close to Kings Cross and St Pancras rail stations moved its

UltraFan for those who may not be aware is a scalable design planned to be 25% more fuel-efficient than Rolls-Royce first-generation Trent engine (Trent 700). It will be suitable for new single- or twin-aisle aircraft entering service from the mid-2020’s and which the company aims to complete design and analysis this year ahead of manufacture and assembly starting very soon together with the world-first electrical technology planned for the next-generation Tempest programme development which is led by Britain and now has Sweden and Italy as international partners (this is now known as the Embedded Electrical Starter Generator or E2SG demonstrator programme) along with a number of other hugely interesting and important programmes such as the Advance2 (this combines new core designs and LP systems with completely new technology while Advance 2 is also recognised as being the eco-systems if you like for demonstrating future products in the large cabin corporate jet market).

The strong end to FY19 and the huge improvement in second half year performance which apart from ongoing efficiency actions may also be put down to the company having overcome the vast majority of turbine blade durability issues on the Trent 1000 family of engines (these power the Boeing 787 family of aircraft) is very welcome news.

On Trent 1000 CEO Warren East said earlier today that the roll-out of fixes was progressing and that he had complete confidence in the new blade design that is due next year and that the number of aircraft currently on the ground awaiting repair is expected to fall to a single-digit number by the end of the second quarter – this being in line with previous forecasts – is but one of many important positive aspects to be found in Rolls-Royce FY19 results announcement. 

While there was reported FY19 operating loss of £852 million, this largely due to a £1.4 billion charge taken on Trent 1000, core underlying profit rose 25% to £810 million. Importantly, cash flow increased to £911 million – this figure being led by higher core profitability and £173 million of Trent 1000 insurance receipts. Importantly, Rolls-Royce told investors that due to its restructuring efforts the annual run-rate cost savings had hit £269 million.

Underlying Group revenue increased 7% to£15.45 billion, operating profit up 25% to £808 million, although the underlying EPS figure was fractionally down reflecting adjustments made on the previous year. 

Civil Aerospace improved its underlying profit significantly with record engine deliveries, good aftermarket performance and improved original equipment (OE) unit losses – down 14%. Defence enjoyed a record order intake of £5.3 billion driving a 26% improvement in order book and healthy cash flow. Power Systems continues to have challenges but revenue did at least increase by 4% and operating margin also improved substantially. 

Notwithstanding that the coronavirus outbreak will likely have on air traffic growth just as it has already hit supply chains of many global companies, Rolls-Royce anticipates core operation profit to grow about 15% this year combined with at least £1 billion of free cash flow. In regard of the 2020 revenue guidance outlook the company is looking for stable to low single digit growth in Civil Aerospace, low single digit growth in power systems, stable to low single digit growth in Defence and ITP Aero stable.

In respect of segmental underlying operating profit guidance Civil Aerospace is expected to achieve 50 – 100 basis points margin improvement, Power Systems between a zero and 100% improvement, Defence stable and ITP Aero between a 50 to 100 basis points margin improvement.

Net R&D cash spend is expected to be broadly stable at £1.1bn, Capitalised R&D should reduce by £100m-£150m reflecting lower capitalisation in Civil Aerospace, Capex (PPE) is expected to be £100m-£150m higher reflecting higher investment in Trent 1000 spare engines as we take further pro-active steps to reduce customer disruption in 2020, Trent 1000 in service cash costs expected to be £450m-£550m, P&L finance costs are expected to be broadly stable (2019: £223m) and cash flow finance costs modestly lower reflecting gross debt reduction in 2019 (2019: £73m). The underlying P&L tax rate is expected to be in the low-to-mid 30s in 2020 (2019: 47.9%); Cash tax paid expected to increase to £260m-£290m (2019: £175m), mainly due to the timing of payments in the US and Germany.

Further details below that may be of interest are repeated straight from the company announcement

Core R&D cash spend increased modestly to £1,108m; good progress on electrical strategy including acquisition of Siemens’ eAircraft business and strengthening of hybrid capabilities in Power Systems; small modular reactor (SMR) development progressing following UK Government matched funding; investment in future opportunities in Defence (Tempest, Future Vertical Lift, B-52)

Net cash excluding lease liabilities improved to £1,361m (2018: £840m); gross debt £1.1bn lower.

Operational:

Civil Aerospace: record 510 widebody engines delivered; further progress in reducing average widebody OE loss, down 14% to £1.2m; 6% growth in large engine installed fleet to 5,029 with engine flying hour growth of 7%. Widebody market share of 64% achieved on new orders in 2019

Power Systems: revenues up 4%; strong power generation growth and market share gains in Asia; increased services penetration; underlying operating profit margin up 90bps to 10.1%

The Rolls-Royce Trent XWB is now the company’s second largest installed flee with leading engines now in their fifth year in service. Fleet leader has flown over 22,000 hours without a shop visit; Trent XWB-84 OE deficit reduced by over 20% in 2019 and remains on track to reach breakeven by the end of 2020.

Trent 1000: roll-out of technical fixes progressing well, further actions underway to reduce customer disruption; in-service cash costs unchanged at £2.4bn across 2017-23. AOG reduction to single-digit by end of Q2 2020, unchanged since November update.

Design progressing on track for the improved Trent 1000 TEN high pressure turbine (HPT) blade, the last major issue to resolve; certification of this component still expected in the first half of 2021 Market environment: mid-term ambition of £1 FCF per share remains supported.

Updated widebody engine delivery expectations of 450 in 2020 and 400-450 per year over the mid-term, following previously announced airframer build rate reductions. Despite challenges in certain Power Systems end markets, growth expected to continue led by mission-critical power generation, rising services penetration and further geographical expansion.

DEFENCE

Defence: excellent performance in 2019 on both orders and cash flow; record order intake of £5.3bn and book-to-bill ratio of 1.6x driving healthy cash flow; 499 aero engines delivered • ITP Aero: good underlying revenue growth of 21% and strong profit growth to £111m • Restructuring plan on track; 2,900 cumulative headcount reduction with run rate cost savings of £269m achieved since the programme commenced in June 2018 Civil Aerospace in-service performance:

Underlying revenue Underlying revenue of £3,250m was up 1% on an organic basis. OE revenue was 2% lower year-on year driven by fewer deliveries of transport engines due to the phasing of orders, including lower volumes of Trent 700s for Multi-Role Tanker Transport (MRTT) aircraft and AE series engines for the C130J and V-22. These were partly offset by increased volumes for LiftSystem hardware for the F-35B.

Service revenue was up 4%, driven by higher LTSA volume for the AE1107 and AE2100 transport engines, together with increased time and materials (T&M) revenue from EJ200 services. Underlying operating profit Underlying operating profit of £415m was £28m lower than the prior year, in line with expectations.

Gross profit of £669m fell 6%, driven by the lower OE volumes in transport, particularly on the Trent 700 MRTTs, and lower LTSA margins due to the non-repeat of one-off customer settlements in the prior year. A modest increase in R&D spend of £4m reflected ongoing investment to support future programmes across our Defence portfolio, with a number of attractive growth opportunities in the coming years. C&A costs were £22m lower year-on-year at £(151)m.

Operational and strategic review 2019 was a very successful year for Defence, with record order intake, strong operational execution, and the achievement of significant milestones in our ongoing R&D projects which will position the business to grow in the coming years in both transport and combat markets. 

Markets remained stable in 2019. The US continues to represent nearly half of the addressable defence spend globally, while the UK and Europe also remain key markets. Rolls-Royce expect higher growth in Asia and the Middle East, driven by regional tensions.

While the budget backdrop in its markets is relatively stable, the company see a number of exciting programme opportunities in the coming years, notably in the Tempest combat programme in the UK and in multiple upcoming campaigns in the US market.

Defence had a record order intake of £5.3 billion, driving 26% growth in the order book. Book-to-bill in 2019 was 1.6x, taking the cumulative book-to-bill over the last five years to 1.2x.

The strength in 2019 was led by services, highlighting the demand driven by an installed base of over 16,000 engines. Key highlights included a five-year contract worth over $1bn to maintain AE1107 engines(C130) for the US Marine 23 Corps, which have now reached the service milestone of over one million flying hours.

Two UK Ministry of Defence support contracts were signed; one for Spey naval engines, and one for the maintenance of the EJ200. A multi-year spare parts order was additionally confirmed for the Adour engines in India. OE orders grew, including four Dreadnought power-plants in Submarines and a LiftFan OE order for LRIP 12 of the F-35 programme.

The company has continued to leverage our existing installed base with the Series 3.5 upgrade kit for the T56 engine, which secured further orders from the US Air Force. Fewer than 5% of the C-130 aircraft in service with the US Air Force currently have the Series 3.5 upgrade kit fitted, presenting a significant opportunity for future orders.

Rolls-Royce delivered 499 aero engines in 2019 to defence and other related programmes. In aerospace, three Bombardier Global 6000s, powered by the highly successful RR BR710 engines were delivered to the German Special Air Mission Wing and German Air Force.

Lift System production ramped up to meet F-35B programme demand and the Boeing MQ-25 unmanned aerial refuelling tanker, powered by the AE 3007, completed its maiden flight. In maritime, the 50th MT30 gas turbine came off the company production line and the company also delivered key early components for the first UK Dreadnought submarine for the Royal Navy.

Operationally, the Submarines business implemented a management restructure, reducing complexity and aligning to the needs of the MOD customer. The company continued to invest in facilities including the revitalisation of the Indianapolis site which is nearing completion while a new 24,000 sq. ft facility in Walpole, Massachusetts is due to be commissioned in late 2020.

These actions to improve efficiency are helping us meet customer demand for cost-effective solutions while minimising the impact on our margins. R&D investment stepped up in 2019 ahead of a period of important upcoming opportunities. The company has made good progress as part of Team Tempest, for which RR is developing a power and propulsion system which will provide fully integrated power and thermal management.

The company was also awarded a two-year contract by the UK Ministry of Defence to develop hypersonic propulsion systems. LibertyWorks which is RR’s dedicated US defence development unit, successfully demonstrated an integrated power and thermal management system for high-power directed energy applications.

During the year the company announced an agreement with Bell Helicopter to exclusively develop an optimised propulsion system for the V280 Valor. Over 50,000 hours of engineering analysis, including digital engineering have already been devoted to refine the RR offering for the B52 re-engining competition and early engine tests were successfully completed in Indianapolis.

Outlook.

The company expects that Defence will deliver stable to low-single-digit sales growth in 2020, with stable operating margins. Longer term, supported by the order intake in 2019 and the pipeline of upcoming new programme opportunities, we expect Defence growth to accelerate. Defence are targeting a number of attractive mid-term growth opportunities the statement confirms particularly those in the USA where the company is extremely well positioned.

Rolls-Royce has also warned that the outbreak of COVID-19 represents a macro risk and is likely to have an impact on air traffic growth in the near term; however long-term growth trends remain intact         

CHW (London – 28th February 2020)

Howard Wheeldon FRAeS 

Wheeldon Strategic Advisory Ltd,

M: +44 7710 779785

Skype: chwheeldon

hwheeldon@wheeldonstrategic.com

@AirSeaRescue  

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