Rolls-Royce: Under financial pressure,
will it be broken up? Jul/Aug 2015

Warren East’s first task as he became chief executive of Rolls-Royce Holdings in July was to give yet another profits warning. A month later he was confronting an activist investor, ValueAct from San Francisco, which had bought a 5.4% stake, raising fears that the company might come under pressure to be broken up, with its marine and land power businesses sold off.

Mr East wrote to its 54,000 employees trying to play down that prospect, but admitting that nothing had been ruled in or out, while he did a quick review of the company’s operations this autumn. He has previously stated that the current strategy of being in power systems on land and sea as well as aero was broadly right. But that view might be challenged by his new investors, known for breaking up or shaking up many companies in America, such as Sara Lee and Microsoft.

The fourth profits warning in 12 months, downgrading civil aerospace profits by over 25% for 2016 and 2017, has added to confusion about what is happening to a company that until two years ago seemed to be on a roll. Now it is beset with difficulties on all fronts, raising the question of whether there is just an unfortunate combination of trading difficulties in its markets or whether the good times were maybe not as good as they were painted in previous accounts, and now is time for a more sober look at the company’s underlying profitability. The answer is: probably a bit of both.

Rolls-Royce’s complicated accounts have ever been a headache for investors and analysts. Now, after four profit warnings and a queue of business woes, they are a persistent migraine. Traditional concerns persist: treatment of upfront finance from risk-bearing partners (Rolls adds to profit; others would see loans); pulling forward profits on long service contracts to make up for little or no profit on actual engine sales; aggressive capitalisation of the cost of developing new engines with slow depreciation being applied in order to flatter yearly profits. Add to that the lack of transparency on the pile of financial derivatives the company runs to handle currency uncertainty and other risks.

Now that Rolls-Royce is facing real business problems on all fronts, its financial prospects and aggressive accounting are coming under scrutiny. The share price has collapsed from over £12 at the start of last year to £7.2 towards the end of August. Net profits have sunk to nearly nothing in the marine division which sells mainly to offshore oil customers, hit hard by the halving of the oil price. The aeroengine business, which accounts for some two thirds of revenues and profits, is going through an expensive transition to new products such as the Trent XWB (for Airbus’s A350) and the Trent 7000 to replace the Trent 700 (Rolls-Royce’s bread-winner for two decades) on the latest version of the A330. Profit margins on both outgoing and incoming products are squeezed—the latter while production costs fall as the learning curve steepens, the former to lure customers to the outgoing Airbus A330, rather than its re-engined successor.

There is more woe. Military engine sales are being hurt by the widespread curbing of defence spending, and a downturn in the markets for both executive jets and regional aircraft are hurting. Rolls sold out of International Aero Engines, which makes engines for Airbus A320s, and so is out of the narrow-body market (80% by volume) for the foreseeable future. Pratt &Whitney, its erstwhile partner, has meanwhile achieved a prime position on the biggest and best new private jets at the expense of Rolls, while the company’s position in the regional jet market has been hurt by reverses to the Brazilian Embraer 145’s progress in the market. The profit impact of the Trent 700 run-down alone is put by the company at £150m this year, £250m next year and £200m in 2017.

An analysis by Berenberg investment bank suggests that more engine sales contracts now being done without a link to long-term service contracts. This means future profits cannot be pulled forward to make the short-term look better. In effect it means less aggressive accounting (Rolls hired a new finance director from outside the company in the past twelve months) and reported profits that are closer to actual cash flow. On the brighter side, long-term service business should continue to grow and be very profitable as the number of the new engines in service grows over the next five years.

Meanwhile the pain will be felt with civil aerospace margins falling from over 12% in 2014 to below 9% next year, before recovering, according to Berenberg estimates, to nearly 12% in 2020. (Rival General Electric has margins over nearly 20%). Even that recovery will require costs to be taken out of the core aeroengine business, something that was difficult to achieve on Mr Rishton’s watch. Rolls is a very traditional company dominated by engineers. It seems that Mr Rishton—an outsider and a finance expert —could not command the authority to drive through changes. It would seem that after four bruising years, he decided to throw in the towel, even if he was not nudged out. On departure he talked wistfully of “a change in lifestyle”.

Mr East made his name as an engineer who built up ARM, a UK start-up, to become the world’s leading designer of the sort of microchips needed for mobile phones, though manufacturing was largely outsourced to Asia. Perhaps those skills of wringing value out of contractors in the supply chain will prove just as important as shaving pounds of costs in Derby.