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Rolls-Royce – Solid Progress By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

 

 

 

Clarity combined with good communication and financial transparency are important aspects of Rolls-Royce FY18 results statement today. Still a long way to go before management have achieved all of their aims but with strong revenue growth, underlying profit doubled to £616 million along with core free cash flow doubling to £641 million, restructuring continuing on track, Trent 1000 fixes in place combined with positive and improving outlook, the words solid progress are the right ones to use in describing the latest set of results. 

To suggest that 2018 has been anything other than a difficult year for Rolls-Royce would be an understatement of course but with hard work, quiet resolve and determination by the senior management team the company comes out of 2018 in much better shape that in entered.

Taking on the challenge of restructuring the leviathan that Rolls-Royce is was never going to be easy proposition and, as alluded above, there is still a very long way to go yet before the company is where CEO Warren East and his team want it to be.

But FY18 results should not just be seen about being a very strong marker of progress being made they should also be seen as providing strong evidence of future strategic intention and of where this great commercial aerospace, defence and power system engineering company intends to be when the restructuring phase is eventually complete.

While headline FY18 numbers reported show that the company swung into a £2.9 billion loss, due to provisions in relation to the fix required on in-service Trent 1000 engines together with a £186 million charge taken on the back of Airbus’s decision to cease production of the Trent 900 engined A380 superjumbo in 2021, note that underlying profit which rose from £317 million in 2017 to £633 million last year was well ahead of expectations in 2018. So too as mentioned above was the most important measure of Rolls-Royce performance, free cash flow.

Operating improvements along with further evidence of structural and cultural change benefits are writ large throughout these results. Separately, attention will no doubt be drawn to the additional announcement from the company this morning that it does not intend to compete to supply an engine for Boeing’s planned mid-size jetliner that comes somewhere in-between wide and narrow bodied aircraft. My view? This is a wise decision and here’s why:

One of the most important ‘constants’ over the past ten years has been Rolls-Royce strategy of seeking to be the dominant ‘large commercial engine’ manufacturer. In December last year the company celebrated the delivery of the 2,000th Trent 700 engine and while production of that engine is drawing toward a close it is worth noting that when the first Trent 700 was delivered in 1995 Rolls-Royce had a widebody engine share of just 13%. Today that figure is close to 50%.

With its pioneering technology and superb well-proven in-service operating credentials, the Trent XWB which powers the Airbus A350 family of aircraft has already achieved a remarkable figure so far of 1,700 engines being either in service or on order, a figure has increased by 25% over the past five years and with Trent 1000 powering the Boeing 787 Dreamliner and Trent 7000 powering the A330neo despite in-service problems on the Trent 1000 that have caused the company severe problem, the future for Trent and ambitions for maintaining and growing large engine market share, the outlook is good. 

So, I for one have no doubts that the strategy to concentrate on large as opposed to smaller single aisle aircraft engines is the right way forward for Rolls-Royce, a decision that has not only proven to have been very successful already in regard of Trent 700, Trent 900 and Trent XWB and that will in my view also ultimately be on Trent 1000 and Trent 7000, I see this as a strategy that will bring ever increasing year on year benefits to the company through the next couple of decades. 

Combined with other members of the Trent engine family, Rolls-Royce now has close to 50% of all large commercial engine sold, an already very strong market share and one that is likely to grow further in the years ahead. Worth noting too that large engine flying hour growth last year was 14% and that the company reduced its original equipment losses by 13% last year to just £1.4 million.

Whilst it is also true that the company has had serious and costly in-service issues on the Trent 1000 that have needed to be addressed and for which the company have stated today are now all in place albeit with an in-year cash cost of £431 million and an increase in total costs of £100 million, the strategy to concentrate on this important and still growing end of the market is absolutely right.

The other reason that it makes absolute sense to concentrate on the larger wide bodied end of the market is remembering that developments have to be paid for through availability of free cash flow. Rolls-Royce is after all a business and it must live within its means. Those means are now increasing and beyond completion of the restructuring phase and Trent 1000 issues, investors should see ever greater rewards. Neither should what the company has been developing for the future in the form of UltraFan, a geared engine design with a variable pitch fan system, this is the next generation of Rolls-Royce engine development, one that with its Advanced Low Pressure System (ALPS) and composite materials will provide significant weight, noise and fuel burn reduction for airlines. UltraFan is expected to be 25% more efficient than the first generation Trent 700 engine. 

So, in my opinion it is far better that the company continues to place development efforts on bringing UltraFan to fruition and eventual success than it is to take on another engine development for which, at this stage, it hard to judge the eventual market and potential reward. Beyond what the company is already doing with UltraFan worth noting too that it is already engaged on other longer term developments including full-electric and hybrid electric flight.

Other activities within the Rolls-Royce stable also showed benefits and this was particularly noticeable in respect of power systems. Defence was essentially flat and unlikely to vary in the shorter term although longer term I believe Rolls-Royce to be well placed to benefit from increased spending on defence and from the air and maritime technology it has developed. ITP Aero which is Rolls-Royce Spanish subsidiary manufacturing aero engines and an important player in the aerospace industry is also doing well. Forward guidance predicts free cash flow and underlying operating profit improvement in FY2019.

The top line FY18 results message from CEO Warren East to shareholders this morning is worth repeating here:

“Despite the challenges we faced on Trent 1000 in-service issues, solid progress has been made realising our ambition to make 2018 a breakthrough year, both strategically and financially. Underlying financial results are ahead of expectations, with good growth in profit and cash flow. Following the restructuring we announced in June last year we are starting to see the crucial behavioural changes needed to sustain our momentum.

We identified and are implementing the fixes to improve the health of the Trent 1000 fleet. Overall our Civil Aerospace large engine fleet performance is getting stronger, especially the Trent XWB-84, which surpassed three million flying hours continuing its exceptional entry into service record.

After a decade of significant investment we remain committed to delivering improved returns while continuing to invest in the innovation needed to realise our long-term aspiration to be the world’s leading industrial technology company.”      

Given the transparency and clarity of message and the progress that is very evident, it is disappointing to see the shares down 3% in early morning trade today. They deserve better and while there remains more work for Warren East and his team to do in the restructuring task, full year figures today clearly demonstrate that good progress is being made.

CHW (London – 28th February 2019)

Howard Wheeldon FRAeS 

Wheeldon Strategic Advisory Ltd,

M: +44 7710 779785

Skype: chwheeldon

hwheeldon@wheeldonstrategic.com

@AirSeaRescue  

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