“We are well positioned to deliver on our near and medium-term commitments despite the increasing challenges and risks around the pace of global economic growth, supply chain disruption and rising inflation that are expected to persist into next year”.
The above remarks from CEO Warren East confirm not only that the company is achieving what it set out to do in the post Covid environment and what has undoubtedly been a period of great trauma for this hugely important international company but also that it is facing up to ongoing challenges with increased optimism.
Despite Rolls-Royce being a predominantly second half orientated company from the aspect of financial reporting, interim first-half year published this morning provide more than sufficient evidence that the company is very definitely on the mend and looking forward to the future.
Free cash flow improved by a massive £1bn and while revenue was essentially flat, the visible impact of increased commercial airline aircraft movements during the first-half of the year, particularly in long-haul flights, provides more than sufficient evidence that wide-body aircraft engine maintenance revenue which has already begun to increase will rebound further as this year progresses and through 2023. To that end, the company has confirmed that wide-bodied engine flying hours have now reached 60% of pre-covid levels. This, together with benefits of actions already taken to improve overall financial operating performance over the past two years, allows me to believe that this hugely important manufacturing and technology company can now look forward with confidence to much better times in the years ahead.
The hard-earned improvement in free cash flow is perhaps the most significant visible aspect of improvement within this set of first half year results. However, the improvement in Power Systems and the interesting and fast-growing aspects of the New Markets division which includes Small Modular Reactors that in my view will provide the company with huge long-term growth potential should not be ignored.
Free cash flow is likely to further significantly improve during the second half of the year. Confirmation this week of regulatory approval for the disposal of the Spanish ITP Aero company with an enterprise value of approximately EUR1.8bn and which is expected to complete over the next few weeks is evidence of what can be expected in the second half. The ITP disposal completes a programme announced back in August 2020 to raise £2bn which would be used to rebuild the balance sheet and return to an investment grade credit profile in the medium term.
Before moving on to discuss the first half year results in more detail let me remind that CEO Warren East who has, along with his excellent senior management team, masterminded the most significant turn round that Rolls-Royce has witnessed in living memory, will stand down at the end of the year. He, together with Chief Financial Officer Panos Kakoullis and his predecessor, Stephen Daintith are deserving of significant credit and thanks for what they have achieved within a relatively short period of time.
Rolls-Royce could not have perceived the massive impact that Covid would have on the commercial airline industry but its response in the face of such adversity is deserving of significant recognition. It goes without saying that I wish Warren East well in whatever challenge he might take on in the future but it would be wrong that I ignore to mention here the absolutely massive challenge that he and his team faced and of how they so quickly responded to such challenges and that when all is said and done, were a very serious threat to the future of Rolls-Royce.
Interim Results
Underlying revenue of £5.3bn was 4% higher led by market recovery in Power Systems and improvement in Civil Aerospace including a £241m LTSA catch up (2021 H1: £160m). Defence revenue was lower against a strong comparative partly due to the non-repeat of legacy spare parts sales in the prior period.
Underlying gross profit of £942m included a £219m Civil Aerospace LTSA catch up (2021 H1: £166m) partly offset by a £(29)m charge in Other businesses related to a legacy business and a £(22)m negative contract charge in Defence due to inflation risk. The £(135)m organic change also included the non-recurrence of legacy spare parts sales in Defence, which had a £45m positive profit impact in the prior period, a foreign exchange movement in Civil Aerospace of approximately £270m reflecting a one-off transactional revaluation credit in the prior period, and other movements which had a positive profit impact in the current period. After taking these items into account, gross profit was slightly ahead period on period.
Underlying operating profit was £125m, due to lower underlying gross profit and included £(371)m in research and development costs with an increase in spend in Defence, Power Systems and New Markets balanced by lower spend in Civil Aerospace. Commercial and administrative costs increased by 16% reflecting the absence of furlough assistance received in 2021, increased activity as markets recover in Power Systems and Civil Aerospace and the ramp-up of activity in New Markets.
Underlying loss before taxation of £(111)m included net financing costs of £(236)m of which £(162)m related to interest bearing debt.
Underlying loss for the year of £(188)m (2.24p per share) included a tax charge of £(77)m (2021 H1: £(29)m) and based on 8,345m weighted average shares in issue.
The company delivered a total of 149 new engines during the first half period of which 78 were large engines for commercial jets. Large engine LTSA flying hours were 4.5m, up 43% year on year. Rolls-Royce states in its report to shareholders that “We are still in a relatively early stage of recovery at around 60% of 2019 levels”.
Total LTSA engines flying hours (which includes Business Aviation and Regional flying hours) of 6.1m were up 33% year on year. Inflation and supply chain challenges have increased and we are addressing the impact through tight cost control and robust long-term contracts with suppliers and customers that aim to pass through inflation risk.
Outlook – “Rolls-Royce states that engine flying hours are expected to maintain the current trajectory and return to pre-pandemic levels in 2024 as global travel restrictions are lifted. In 2022, we expect 350-400 total OE deliveries and 1,100-1,200 total shop visits. We are focused on keeping costs low and maintaining productivity gains as shop visits increase. This supports our updated expectation for good (previously modest) revenue growth and improved profitability as well as a substantial improvement in trading cash flow in 2022, compared with the prior year”.
Five Civil Aerospace operational value drivers are highlighted – Maximising service receipts, reduce service costs, Improve OE (Original Equipment) margins through increased productivity, controlled overhead costs and a focused purchasing strategy to reduce the cost of components and assembly, Grow Business Aviation and finally, accepting that the investment cycle has now passed its peak with less intensive new product introduction, the company believes that the nature of [future] spend will reflect increased partnering to reduce capital intensity and a rebalancing towards cost reduction and product maturity work.
Trading cash flow was £63m, £1.1bn better than 2021 H1 driven mostly by higher EFH receipts. Shop visits also increased but at a slower pace. Working capital was modestly negative, but significantly better than the prior period, with higher inventory partly offset by increased payables with higher RRSP payables and warranties reflecting the recovery in flying hour and shop visit volumes in the first half. Trading cash flow included £(265)m outflow related to the settlement of excess foreign exchange derivative contracts and there was limited net impact from OE concessions in the period.
Defence
Underlying OE and Service based revenue decreased by 7% as also did operating profit by 30%. Timing on the signature of the next tranche of F35B and lower engine sales in Naval led to a 6% reduction in OE revenue. Services revenue was £122m (12%) lower partly due to the non-repeat of a large legacy spare parts sales in 2021. The remainder of the decline related to engine flying hours and delays from suppliers.
Underlying gross profit of £326m was £77m (19%) – lower than the prior period and included the non-recurrence of legacy spare parts sales which had a £45m positive profit impact in the prior period. The 20.3% gross margin in 2022 H1 reflected a more normal mix of activity. Product margin remained strong through the period despite supply chain and labour inflationary challenges, and a £(22)m charge in respect of inflationary increases to the costs to deliver long term services contracts.
The company states that:
“Our Defence business continued to perform well, with the business cycle normalising in 2022 following two years of increased support from customers to offset COVID-19 challenges. We achieved our first milestone on the B-52 programme with the completion of a review in support of the F130 integration activities onto the airframe. The rapid twin pod test to validate our integrated design for the B-52 will commence in the coming months on our outdoor test stand at NASA’s Stennis site in Mississippi. Our Defence portfolio of long-cycle products is not immediately exposed to short term changes in defence demand, but the increase in military activity and spending this year has further underpinned the longer-term outlook for the business. We have seen continued impetus on key future programmes including Tempest, the new fighter jet programme which is targeting entry into service in 2035, and the next generation nuclear submarine programmes for the UK. We await the decision on the Future Long-Range Assault Aircraft (FLRAA) programme in the US, with the outcome expected in the coming months”.
Order intake was £1.4bn with a book-to-bill ratio of 0.9x. Our £6.5bn order book and the long operational life of our products give high visibility of future revenue. Order intake in the first half included a new 11-year contract to support the Adour engine, which powers the Hawk jet trainer aircraft.
Defence Outlook:
The company states that “it expects modest revenue growth in 2022, helped by an easier comparable in the second half of the year, with strong order book cover securing near term activity in all our end markets. We are increasing investment to support future growth and recent orders, develop products that will help decarbonise the military, and modernise our facilities. This, combined with a return to more usual levels of spare parts sales in 2022, is expected to result in a low double digit operating margin (new guidance) and strong cash conversion”.
Power Systems
The Interim results statement confirmed “demand for products remains very strong with continued record order intake in the first half. Demand has been strongest for power generation with orders including mission critical backup power for data centres for very large customers worldwide. Global supply chain challenges have continued to impact the availability of key components. This is restricting our pace of revenue recovery and drove a substantial increase in inventory in the first half which we aim to reduce in the second half. We have a dedicated taskforce in place to mitigate risk and accelerate OE deliveries with actions such as increased risk monitoring to identify and resolve supply chain issues early, and technical substitution of certain cast parts with 3D printed alternatives”.
Order intake of £2.1bn was 53% higher than the prior period and included the highest quarter for order intake on record. The book-to-bill ratio was 1.5x with strongest growth in demand in power generation governmental and industrial end markets. Order cover for 2023 is building well and the company states that it is already at full capacity for 2023 in some market segments.
Underlying revenue of £1.4bn was up 20%. Aftermarket services grew 17% with increased activity in both stationary and mobile solutions. OE revenue was up 21% with particularly strong sales in power generation, marine and governmental end markets.
Underlying gross profit grew by 37% to £401m and gross margin increased by 3.7%pt. This reflected the mix of activity with an increase in higher margin services and lower warranty costs as well as improved utilisation in our manufacturing facilities compared with the prior period when we were in the earlier stages of recovery.
Underlying operating profit was £119m, up £80m giving an operating margin of 8.7%. The increase in commercial and administrative costs reflected higher employee costs as activity increased as well as wage inflation pressures. The 17% increase in research and development costs reflects investment in new product development and transitioning products to sustainable fuel alternatives as we help our customers towards net-zero emissions.
Trading cash outflow was £(76)m (2021 H1: £71m), with a negative cash conversion as inventory increased to meet growth demand and to manage the supply chain challenges. This also reflected our investment in a 54% non-controlling stake in electrolysis stack specialist Hoeller Electrolyzer.
Power Systems Outlook
The company states that:
“We expect good revenue growth in 2022 supported by record order intake, partly held back by the current global supply chain constraints. We expect our operating margin to be broadly flat, with higher activity levels utilisation offset by continued inflationary pressures and increased research and development in net zero solutions. Cash conversion is expected to improve in the second half with some of the recent inventory build unwinding, but is still expected to be lower for the full year”.
New Markets
New Markets is the reporting segment for investment phase businesses focused on addressing the opportunities that are being created by the transition to net zero and addressing the climate change challenge. This segment comprises two businesses that have no significant revenues but high future potential: Rolls-Royce SMR and Rolls-Royce Electrical.
The small modular reactor (SMR) design is going through the UK Generic Design Assessment (GDA) process, which is expected to take several years to complete. Estimated costs are mostly covered by third party investment and a UK Government grant in addition to £50m (approximately 10% of the total) self-funded by the Group. Factory sites where the company will produce heavy vessel modules for its SMR are being identified in preparation for the build process, with minimal infrastructure investment prior to receipt of first order. The company states that “We welcomed the decision by the European Parliament this year to categorise nuclear power as an environmentally sustainable energy source in the EU taxonomy for sustainable activities”.
Electrical business supports electrical engineering projects across the Group enabling it to take an agile approach to specialist engineering resource. In the first half, Rolls-Royce announced the development of turbogenerator technology which includes a new small engine designed for hybrid-electric applications in Civil Aerospace and Defence. Importantly, in July the company signed an agreement with Hyundai Motor Group to collaborate on bringing all-electric propulsion and hydrogen fuel cell technology to the advanced air mobility market. Urban air mobility customers are targeting entry into service by 2026, using our torque dense, compact, and highly reliable electrical propulsion units.
The underlying operating loss of £(48)m was £(20)m was greater than the prior year period comparative as the company grew the workforce in both businesses with a focus on engineering capability for research and development activities. The rate of cost increase is slightly lower than expected as a result of a tight labour market in experienced engineers with certain skills and technical expertise.
Trading cash flow of £(30)m was £18m better than operating losses mainly due to the receipt of third party funding and investment for the SMR programme.
Outlook
The company states that “Investment in research and development will continue to increase in the second half of the year as we add to the engineering teams and take our new products through development and regulatory processes. Trading cash outflow guidance has been updated, and is now expected to be around two thirds of the underlying operating loss in 2022 (previously £100m better), with the difference mainly due to the phased receipt of secured third party equity investment in Rolls-Royce SMR”.
CHW (London – 4th August 2022)
Howard Wheeldon FRAeS
Wheeldon Strategic Advisory Ltd,
M: +44 7710 779785
Skype: chwheeldon
@AirSeaRescue