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ROLLS-ROYCE

ROLLS-ROYCE – DIVERSITY AND STRENGTH IN EQUAL MEASURE
By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

25 Jul 13. Rolls-Royce shares may be up this morning on the back of excellent first-half 2013 performance but it is clear that senior management are getting increasingly concerned with regard to cost and cash. Nonetheless, these results are in most respects excellent and in my view they more than justify the 37% increase in the company share price so far this year.

Cost and cash flow concerns at Rolls-Royce are not exactly a new issue to those of us who as analysts have followed the fortunes of this fine and well managed company over the past few decades. Concerns with regard on cost and cash flow are certainly justified. But in my view these should be taken as full recognition by the board that work needs to be done as opposed to signalling expectations that resolving these issues will require a radical change in strategy. The bottom line is that costs are rising faster than revenue and that as CEO John Rishton described, cash outflow of £461m during the period is “unacceptable”.

I will return to the cost and cash flow subject later but first a quick look at some positive basics within the Rolls-Royce H1 results that included the order book rising 15% to £69.2bn, underlying revenues excluding Tognam rising 9% to £7.3bn and underlying profit before tax performance rising on the same basis by 32% to £840m. These are as I say excellent results and the dividend has not surprisingly been increased by 13% to 8.6p.

In stark contrast and just to make the point of how this company has grown in stature, global size and strength over recent years it may be worth comparing H! 2013 results with those of fifteen years ago when for H1 1998 revenue came in at £2bn, profits at £135m and the order book stood at what was then a record £10bn. Those results were actually considered good at the time but too few realised the forward potential. Today Rolls-Royce shares are trading at around 1226p – back in July 1998 they traded at just 185p!

In terms of H1 2013 sales and profit performance civil aerospace accounted for £3.2bn of total revenue, £486m of underlying profit before financing costs and at £56.7bn (up 14%) approximately 82% of the total order book. Revenues and underlying profit performance from Defence improved although the order book declined. The order book for Marine together with revenue over the first six months of the year improved although profit slightly declined. Revenue in the Energy division slightly increased as did the order book and losses declined. With the benefit of acquisition and consolidation Power Systems revenue came in at £2bn and the division had profits of £72m. Energy apart this is low by traditional Rolls-Royce standards and an area that will no doubt be targeted by management for potential margin improvement.

Over the past fifteen years considerable effort has been placed by successive company management to achieving manufacturing efficiency gains right across all parts of the group. On this matter suffice to say that the vast majority of Rolls-Royce manufacturing plants today are very highly invested, that they are efficient and that they contain some of the most sophisticated design, material technology, manufacturing and testing facilities available within an advanced nation. Achieving improvements and internal efficiency gains remains a constant process of hard work just as does pushing forward the need for this to occur right the way down through the supply chain. Investing in new and improved manufacturing processes with the aim of being lean and mean in terms of manufacturing prowess had long been recognised as a way to enhance the process of cost efficiencies.

Nevertheless, other issues that relate to cost and efficiency gains are not quite so easy to control as the benefits to be achieved by investing in process, manufacturing and design capability. Rising raw mat

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