Rolls-Royce – PACE, DEPTH, SCALE, PLUS A WELL DEFINED AIR OF QUALITY
By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

13 Feb 14. Global defence cuts may have reasoned a more cautionary stance on FY14 forward outlook guidance from senior management but that takes nothing away from the fact that 2013 was yet another year of superb financial performance at Rolls-Royce. Nevertheless, on the back of the more cautionary guidance that anticipates further negative impact to group revenue and profit performance to be caused through the impact of ongoing global defence cuts the company has confirmed that 2014 profit performance is likely to be relatively flat. Note though that the company has also confirmed an expectation that profit growth will resume in 2015.

Whilst forward guidance is hugely important I have to say that I am somewhat surprised that analysts appear to have been caught off guard by not readying themselves to anticipate a greater level of negative impact on companies like Rolls-Royce from large scale cuts in US, UK and other mature nation defence spending. While the impact of cuts to defence spending are of concern I take the view that given the overall size of defence related activity within the overall portfolio of interests initial concern is being overdone. Indeed, given the still huge growth potential evident in the vast majority of other activities in which the company engages the prospect of lower revenue and thus profits in the defence division (a 15% to 20% decline in FY14 revenue is being forecast) together with an anticipated slowing in the Marine division justifies a 9% fall in the price of the shares. There we are – markets are of course almost always to be considered right aren’t they but my own view is that given that Rolls-Royce is such a well diversified engineering group and one that has superb international scale, reach, depth, quality and diversity of strengths, whilst new on defence is clearly disappointing the company has never been in such a strong position to ride a divisional storm.

Year after year Rolls-Royce drives better performance and it does so not just on the back of quite amazing strength in its primary aerospace engine market but also because it has never been shy about investing in its own future. The strategy remains to concentrate on gas turbine and reciprocal engine technology. Customer, Concentration, Cost and Cash remain the priorities for management but just as important is that the company continues to invest in people, skills, product, research, technology and development. That more work needs to be done on cost is fully recognised by senior management but that is not to suggest that this fine company is anything other than close to the top of its game in terms of engineering ability, manufacturing efficiency, international competitiveness and people. Serious though any specific downturn in divisional activity is I am then far less concerned than some that the impact of what I hope will be a relatively short period of adverse cyclicality and sentiment in defence and marine and I continue to believe that as a very well diversified and managed international group Rolls-Royce can continue to look forward to a sustained period of success.

FY2103 results can be summarised as order book, up 19% to £71.6bn (£60bn of which is within the Civil Aerospace business), underlying revenue up 27% to £15.5bn, underlying profit before tax up 23% to £1.759m and proposed shareholder dividend to rise 13% to 22p. Tognum, now part of the Power Systems division, was consolidated in group results for the first time and of note too is that cash flow further improved and the company ended the year with a small net cash balance of £350m. Capital expenditure excluding Tognum was £687m, well up on the £491m spend of 2012 and free cash flow for the year was £781m. Group margin performance improved to 12.7% from 11.5% in 2012. The balance sheet remains very strong with net assets o