Qioptiq logo Raytheon Global MilSatCom

Rolls-Royce – Rising to the Challenge By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

rollslogIt is I suppose hardly surprising that being one of only a handful of remaining large and successful engineering companies that are still based here in the UK that a series of profit warnings over the past two years should have attracted serious media and investor attention. Today Rolls-Royce has attracted a lot of attention and justifiably so.

Now well into the process of sorting a string of important issues many of which lie at the heart of the poorer performance seen of late it is unfortunate that this hugely important company is going about the process of making big changes against a background of sometimes damaging, dangerous and unnecessarily negative speculation. Such is life and it is a pity that many choose to ignore that the company is still doing most of what it does very well. The important point though is that it is now doing whatever it takes to bring about real bottom line progress.

Delivering better performance will of course take time but under Warren East I am in absolutely no doubt that the company will deliver financial and other improvements that it has set out to do in the years ahead. As to the wide ranging and sometimes damaging speculation that has surrounded Rolls-Royce in recent months, my own view is that much of this is to do with a lack of understanding or indeed, genuine interest on the part of some in relation to the requirements of nuclear engineering. Whatever, while I absolutely accept that the company needs to be more adept and also, to accept some of the more genuine concerns and criticisms lobbied by those that really do matter I would advise that the best thing to do about those proffering damaging speculation is that they are best to be completely ignored.

Pleasingly there can surely be no accusations about lack of detail and transparency in the latest set of results from Rolls-Royce. Detail and new understanding is available in abundance just as the CEO said that it would be. Hopefully this will lead to the company being better understood by those that would sometimes choose to do it down because of a lack of understanding of how important this company is to the UK or for whatever other reasons that they choose to do this. The year ahead will be crucial for everyone working in senior positions at Rolls-Royce and they all know that they have to deliver. That performance improvements will take far more than just a year to achieve is well understood but what matters this year will be not just be evidence that Rolls-Royce is rising to the various challenges it faces but that the prospects for full delivery are real. I for one believe that they certainly are.

Cutting the dividend for the first time in 24 years is certainly not something that CEO Warren East would have wanted to do but given the previously announced challenges that the company is facing it was certainly the right thing to do. Markets have in my view judged FY2015 results together with the full statement from Warren East very responsibly marking the shares up 14% in early morning trade.

Importantly CEO Warrant East has in his statement reminded of what the company is doing and has already done to resolve a number of issues that have been responsible for the series of profit warnings. These have included setting up a transformation team to focus activities, add pace and simplicity to a business that has clearly allowed itself to become too complicated and top heavy. The plan to reduce costs has already begun and the intention is to produce cost savings amounting to between £150 million and £200 million per annum. Roughly 50% of these cost savings have already been identified and the company has chosen to take an exceptional restructuring charge of between £75 million and £100 million in the current 2016 year. Further actions are either underway or planned with the aim of generating additional savings in 2017.

Importantly guidance for 2016 is unchanged and the statement from Warren East concluded that “despite steady market conditions for most of our businesses it will be a challenging year as we start to transition products and sustain investment in Civil Aerospace and tackle weak offshore markets in Marine” adding that “the pace of investment required to transform the business creates near-term pressure on free cash flow. Longer term Marine and Aerospace are expected to reduce costs by £145 million by 2017 although the company says that the successful roll-out of new engines, led in particular by the Trent XWB, 1000 and 7000, together with a growing aftermarket, are expected to drive significant revenue growth over the next ten years as it builds toward a 50% plus share of the installed wide-body passenger market.

However, while the impact of the transition to the Trent 7000 has reduced Trent 700 deliveries this will hold back Civil Aerospace profit in the near term. Nevertheless, the company is confident that the important investments it is making to transition production will create a strong platform to drive customer service, improve margins and provide strong cash flows. Other cost related benefits are also likely to kick in from the end of 2017.

In his statement the CEO reminds that the company “needs to sustain a healthy balance sheet to ensure we have the financial flexibility to maintain a strong investment grade credit rating”. He has also said “that the first half dividend for 2016 was also likely to be halved” although on a more positive note added that “our strong order book continues to grow, built around market-leading products and services and that this provides us with an outstanding opportunity to deliver long-term profitable growth and capture significant incremental market share”. The importance of the transformation programme that is currently going on and that includes simplification of all processes, systems and management structures should make the company far more resilient. This is a process that is long overdue and it is pleasing to see that they have made a very good start to hopefully returning the company to sustainable resumption of long term growth.”

I have previously discussed most issues that relate to why Rolls-Royce finds itself in the position it does. In short these are a combination of a too high fixed cost base, implementation over the past few years of significant manufacturing efficiency investment now coming on stream but have required a period of dual production from old and new plants, civil engine transitioning, weakness in defence following sharp cut back in defence spending by western governments since 2010, the serious impact that a falling oil price has had on Marine leading to a sharp fall in orders for ships across the world and that has meant RR has suffered a sharp decline in orders for the wide array of compulsion systems and related equipment that powers and drives ships and that new engines such as the Trent 7000 are only just in the build-up phase of production.

Below is an abridged version of what Warren East told shareholders today in relation to market developments that Rolls-Royce rightly believe will continue to drive long term growth. In doing so it si pleasing that East is addressing another concern long expressed by markets – that of the need for increased levels of disclosure, transparency and communication.

“The long-term positive market trends for our leading power systems remain unchallenged despite some near term uncertainties that are likely to impact the small aerospace engine production volumes and service activity on older wide body engines over the next couple of years”. These remarks may partly reflect that older, less fuel efficient aircraft are now being taken out of service by airlines at a faster rate than had been previously anticipated.

Warren East went on to say that the “trends driving demand for growth in large passenger aircraft, corporate jets and maritime activity remain strong; in particular a growing aspirational and mobile middle-class, particularly in Asia, and globalisation in business, trade and tourism. In addition, capacity constraints at the airframe manufacturers and a strong underlying demand for newer, more fuel efficient aircraft, should provide resilience to manufacturing schedules over the next few years as the industry transitions to new airframes during a strong replacement cycle”. I can hardly disagree with such a statement and we are, as further recent $2.7bn engine order from Norwegian for Trent 1000 engines for its fleet of Boeing 787 aircraft confirmed and that had followed a massive $9.2bn order from Emirates Airlines ten months ago for the supply of Trent 900 engines for a fleet of 50 Airbus A380 aircraft it is acquiring.

“East went on to say that most significant short-term challenge that has emerged in 2015 relates to the changing demand for our Trent 700 engine as Airbus transitions production from old to new airframes. This has had a knock on effect on both demand for and pricing of the remaining engines to be delivered”. “Once completed” he said Rolls-Royce “will benefit from an exclusive position with the new Trent 7000 on the A330neo”.

In the near-term the profit impact of this transition is negative although we have also been told that the impact of lower pricing and gross margin is exacerbated by the accounting effects of changes within the large engine aerospace product mix as the company transitions to a portfolio increasingly comprising “unlinked” platform positions. It is though important to realise here that the roll-out of new engines will significantly grow our market share and the installed base of new engines that will deliver strong aftermarket revenues for decades to come. Within a very short time Rolls-Royce will have over 50% of the global wide bodied aircraft engine market.

Warren East then went on to talk about the initial findings for a detailed review of operations saying that “our strategic priorities for 2015 remained largely consistent throughout the year, with a clear focus on the customer, innovation, and on driving long-term profitable growth. However, with short-term market conditions around us changing, it has been appropriate to review these priorities as we look to the next three or four years”. “Since July” he said that Rolls-Royce “have been conducting a review of operations and that” having presented the initial conclusions in November the company had sought to share strengths and weaknesses of the business portfolio” while at the same time “updating on management’s future focus and priorities around delivery and transformation”.

“The review of operations” he said “had highlighted a number of opportunities to drive further performance improvements over and above the extensive restructuring programmes already underway. He said that “as the company grew as an organisation it had embedded costs and complexity into the business that, during periods of significant investment and product transition such as now are impacting our performance”. “Higher costs” he said presented “a significant opportunity; to simplify what we do and sustainably reduce the cost of management, creating a more streamlined, resilient and sustainable business”.

The strategic review concluded that the strategic focus had led the company “to recast priorities” within a continuing theme of developing our products, services and order book to drive long-term profitable growth”. This would lead to continued investment in developing excellence,   driving a manufacturing and supply chain transformation which will embed operational excellence in lean, lower-cost facilities and processes and finally, leveraging our installed base, product knowledge and engineering capabilities to provide customers with outstanding service through which we can capture aftermarket value long into the future. Rolls-Royce TotalCare® is a part of this thought process and it is noticeable that the company has chosen to present this important process of future performance into a simpler narrative.

 

Delivery of all that Rolls-Royce has set out to do will take more than a year and may well take three years to complete. But that what needs to be done has been defined, prioritised and already begun is significant. The whole management structure is being simplified as are processes, decision making and execution.

 

For my part and having observed this particularly in relation to financial performance, investment in design and production engineering capability and in how it has thought and always prioritised research and development and long term investment in product and people I am content that Rolls-Royce is under the new CEO not only has a correct forward strategy but that it is also moving forward very much in the right direction. In respect of new widebody engine products that will sustain the civil aerospace division focus this past year has continued to be on completing development and testing of the new Trent 1000 TEN and the Trent XWB-97. The company has said that the results of initial tests on both engines are broadly in line with expectations. In December 2015 the Trent XWB-97 flew for the first time and has since undergone rigorous testing in various conditions. The Trent 1000 TEN has also completed several major milestones over the past year and a hybrid Trent 7000 that was produced to de-risk the development programme, ran for the first time and is now being put through its paces with a series of rigorous tests.

 

Soo much for the future, what of the here and now? From my perspective Rolls-Royce is a very strong company financially and while it is certainly true that cash flow weakened last year leading to an end year net debt position of £111 million we should reflect in this that the company acquired shares worth £414 million (mainly in respect of the sale of Energy activities the previous year) that dividend costs for 2015 have totalled £421 million and that, albeit down on 2014 due to a sharp fall in retained earnings, net assets are still ahead of £5bn.

 

While underlying profits before one-off items were down 12% in FY15 on revenue down 1% – both on a constant exchange rate basis – it is pleasing that no change has been made in the trading outlook for 2016. This in itself should be seen as an important positive as also should be the 4% growth in the overall order book to £76.4bn and the increase in market share for wide body aircraft engines. Research and development costs were £64 million higher than the previous year reflecting spending on key programmes such as the Trent 1000 TEN, the Trent 7000, and the Trent XWB-97. Not surprisingly particularly given the sharp reduction in net funds and overall free cash flow – albeit that the latter figure was in the event very much better than had been previously signalled – led to the final dividend being cut by 50%. In terms of divisional underlying profits performance declines were seen in Power Systems, Marine and Civil Aerospace, defence improved profits but not sales and pleasingly, Nuclear made very good progress. The closing order book for Civil Aerospace was £67bn.

CHW (London – 12th February 2016)

Howard Wheeldon FRAeS

hwheeldon@wheeldonstrategic.com

Tel: 07710-779785

Back to article list