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Rolls-Royce – Suffering Profit Headwinds Now To Enable Tomorrows Growth By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

 

rollslog30 Jul 15. Clearly, Rolls-Royce first half results are, on the cover at least, disappointing in the sense that they are down on those of the previous year. But look deeper and there are far more positive reasons to be found as to why Rolls-Royce is taking such large amounts of pain now as it moves to place itself in a formidable position to prosper in the years that lie ahead. With a new CEO at the helm, an excellent strategy and being well financed and structured, my view is that despite short term pain the future for Rolls-Royce really does look very bright.

As to the where, why and now we have been reminded this morning that while new products are transforming the Civil Aerospace business some of the older, more profitable programmes have peaked and are now starting to decline. Technology does not stand still in this business and the reference the company is making here is primarily to the Trent 700 (engine of choice for the Airbus A330 and that has a 58% market share) which is regarded as now being in the later stage of its OE delivery lifecycle, although still growing aftermarket revenues of course. This transition creates near-term challenges as newer programmes typically see lower pricing for launch customers and higher initial costs. However, the roll-out of new engines will significantly grow Rolls’ market share and the installed base of engines that will deliver aftermarket revenue for decades to come.

At the same time it is clear that as new investment in put in by Rolls-Royce costs are fast being taken out. New advanced blade casting facilities in Rotherham for instance will halve the time it takes to manufacture blades. This has already led to the closure of two facilities at Ansty and East Kilbride. Note too that restructuring in Civil Aerospace announced a year ago has led to the closure of a site in Brazil, further rationalisation in the UK and completion of 60% of a planned 2,600 reduction in headcount.

I suspect that I can do little better here than repeat some of what the company has itself stated this morning. I do so because I firmly believe that the strategy they have in place is the right one and that by investing for the long term is absolutely right. The company stated in its report today that “it is important that we sustain R&D investment in future market-leading products”. It goes on to say that “as a result, we are currently undertaking a major investment programme in new technology, focused on our next generation Aerospace designs, Advance and UltraFan®. (Note: the current edition of the Royal Aeronautical Society Magazine ‘Aerospace’ includes a piece written by me on Rolls-Royce future engine technology)

The report continues by saying that ‘by spending on research and technology development now presents us with a suite of technologies that will have applications across our portfolio.’ To realise such ambitions that they have in terms of new designs the company are investing in advanced manufacturing capability and critical testing facilities, including a composite technology hub in Bristol and a new power gearbox test facility in Dahlewitz, Germany. These are large scale changes and they fit alongside huge investment and change that has and continues to take place at the main civil engine production site in Derby which I have previously written on.

In addition the company has sought to remind investors that it has strengthened existing partnerships and established new relationships to realise its ambitions. For instance, during the first half they have strengthened the ITP turbines joint venture with Sener Grupo de Ingenieria SA and also agreed a 50/50 joint venture with Liebherr-Aerospace to develop manufacturing capability and capacity for power gearboxes.

In the Land & Sea business the company is continuing to develop innovative technologies and in Marine they have recently extended the range of permanent magnet thrusters with a new Azimuth model. The business is also drawing on expertise within Aerospace to develop a leading position in the emerging area of ship intelligence through heading up a new research programme, funded by the Finnish Government, to explore technology required for the creation of autonomous vessels. In Power Systems Rolls-Royce are investing in more environmentally-friendly engines, including a new generation of hybrid power packs for locomotives that are more efficient, quieter and significantly reduce emissions, and new test facilities in Friedrichshafen.

So there is plenty going on and it is all bound up in looking to the future and ensuring that the company remains at the leading edge in terms of design technology, manufacturing ability and competitiveness.

The company had in any event in July 6th given further guidance that the reduction in anticipated volumes of Trent 700 engines, together with weaker OE demand for business jet engines and regional aftermarket that revenues and profits in commercial aerospace would mean profits would be paired back. Added to this, weakness in offshore markets has and will likely continue to impact adversely on the Marine business and the company has now stated that it anticipates this will likely continue through this year and next.

Another factor that has been highlighted today is that In the future an increasing proportion of new engines will be sold to the air-framer on a sole-source basis, in particular the new Trent XWB and Trent 7000. As a result, a significantly larger proportion of future sales will be accounted for on an ‘unlinked’ basis. While as such this factor does not change cash flows, it does change when profit will be recognised across original equipment (OE) and aftermarket (AM) contracts. Under the ‘unlinked’ accounting system the understanding is that engine sale and aftermarket contracts are accounted for separately. This typically results in lower upfront profit recognition on engine delivery and that a significantly higher proportion of profit emerges during the aftermarket period. This compares to ‘linked’ accounting, when what is termed as a blended margin is applied across the engine sale and aftermarket contracts.

So, a lot of this pain is about investing for the long term and that is surely absolutely the right thing for Rolls-Royce to do. Here I can do no better than yet again repeat what the new CEO Warren East said in his remarks to accompany the half year results this morning, “In the near term, we are managing a significant transition from mature engines to newer, more fuel efficient ones, such as the Trent XWB, Trent 7000 and Trent 1000. At the same time, we are taking appropriate actions to mitigate the effects of weakness in our offshore marine markets. While these create a profit headwind in the near term, it is critical we successfully deliver our product launches, complete our supply chain transformation and sustain investment in our businesses to strengthen their competitive positions. The initial phase of my ongoing operational review has and will continue to concentrate on how we drive improvements and sharpen our focus to make us a more resilient and sustainable business”.

The approach taken by Warren East appears to have gone down well with analysts today and despite results the shares have remained firm. For all that we need to remember that Rolls-Royce first half results showed that revenue rose 2% to £6.37bn at the reported level and £6.45bn at the underlying level. Pre-tax profits may have fallen to £310 million at reported level and £439 million at the underlying level, down 57% and 32% respectively, but there were plenty of positive highlights as well. For instance, the group order book was up by £2.8bn to £76.5bn and the interim dividend payment to shareholders was raised 3% to 9.27p per share. The report reminded that large orders had been received Trent 900 engines and Total Care® service support to Emirates Airlines and that this helped push the civil aerospace order book up 5% on the figure disclosed last year to £66.4bn.

(My apologies by the way for writing a second ‘commentary’ this morning but when the two largest and what I must regard as the two most important international aerospace and defence manufacturing companies based here in the UK and that are vital for our national economy in terms of jobs, skills, export benefits and also in what they produce for the national exchequer report first half results on the same day I feel that I am obliged to comment on each. Indeed, this becomes even more necessary when one realises with some degree of shame, that our public service broadcaster, the BBC has apart from a brief markets mention, chosen to ignore both BAE Systems and Rolls-Royce on its website today!)

hwheeldon@wheeldonstrategic.com

Tel; 07710 779785

   

 

 

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