Go long or short on over 13,000 international shares with CFDs
or spread betting, or buy and sell shares via our share dealing service.
Rolls-Royce has had to patiently tinker under the hood since it started stalling back in 2014, but now the British engineering giant is preparing to rebuild the engine as it gets ready to undertake its biggest restructuring for almost two decades. So, is it all systems go at Rolls-Royce?
‘Our world-leading technology gives Rolls-Royce the potential to generate significant profitable growth. The creation of a more streamlined organisation with pace and simplicity at its heart will enable us to deliver on that promise, generating higher returns while being able to invest for the future,’ – Rolls-Royce chief executive Warren East, June 2018.
Rolls-Royce has long been at the forefront of British industry since starting out as a car manufacturer in 1906. Having evolved in the early 1970s into an engineering company, it has since grown to become one of the world’s most prominent suppliers of high-tech equipment and technology, helping to build everything from aircraft engines, combat jets, ships, nuclear submarines and power plants across the globe.
After issuing five profit warnings since 2014, Rolls-Royce has been quietly working to rebuild the engine that has been stalling over recent years.
Having initiated a plan soon after taking over at the helm in 2015, chief executive Warren East has been focusing on stabilising the business and proving the company has the ability to remain at the forefront of innovation. This has been done by investing in new manufacturing facilities, and scaling up the business to meet its customer’s needs. Now, having returned the business to profit following an eye-watering loss in 2016, the CEO is preparing for the next phase of his plan.
Learn more about Rolls-Royce: an iconic UK stock
East has already cut thousands of jobs, with over 4000 fewer staff on its books now than at the end of 2014. However, he is now ready to make a fresh wave of cuts as part of the biggest restructuring of Rolls-Royce in almost two decades.
So, will the Rolls-Royce engine cough and splutter, or fire on all cylinders?
East was brought in to turn the company’s fortunes around after it entered troubled waters in 2014, when a challenging year saw a rare decline in revenue and a 96% dive in pre-tax profit. While it managed to initially avoid losses, performance in 2015 continued to stagger before Rolls-Royce plunged to a £4.6 billion loss in 2016. This marked the biggest loss in the engineer’s history after the depreciation of sterling following the UK’s Brexit vote caused it to lose an astounding £4.4 billion.
Read more about how Brexit will impact airlines and the wider aviation industry
Still, Rolls-Royce’s profitability and cash flow were both squeezed, regardless of the one-off hit to results, and it found itself accumulating debt after its significant hoard of cash withered away, exacerbated by the necessary investment the company had to make while navigating tough waters. In addition, shareholders had to cope with lower payouts after East cut and froze the dividend under the initial phase of his plan launched in 2015.
|Adj pre-tax profit (loss)||1760||1617||1432||813||
|Pre-tax profit (loss)||1960||67||160||(4636)||4897|
|Free cash flow||781||447||179||100||273|
|Shareholder pay-out (p)||22||23.1||16.4||11.7||11.7|
|FCF: pay-out ratio||2.2x||1.1x||0.4x||0.3x||1.3x|
|Adj net (debt)/cash||1939||666||(111)||(225)||(520)|
(Source: Rolls-Royce reports, figures may be restated in certain years)
Although stronger sterling played its role in the company’s huge improvement in 2017, leading to a £2.6 billion profit from its hedge book, Rolls-Royce’s performance last year was better than anyone expected, with profit and cash flow both smashing forecasts. And while investors will also be wary over the stagnate dividend, rising debt and a rare dip in the order book, shareholders embraced the company’s performance and have since thrown further support behind East once he unveiled the next big phase of his restructuring plan.
‘Rolls-Royce announces the next stage in our drive for pace and simplicity with a proposed restructuring that will deliver improved returns, higher margins and increased cash flow. This will support our long-term ambition to be the world's leading industrial technology company,’ – Rolls-Royce.
Having kept a tight lip since announcing a major restructuring plan was on the way back in January, East has now outlined the details to create a ‘simpler, leaner and more agile organisation’. This will see it trim about 9% of its global workforce and strip down the business to three divisions from the current five.
Rolls-Royce has shown it is ambitious, aiming to overhaul the business in just 18 months with the hope of yielding £400 million of annual cost savings by the end of 2020, building on the £200 million of run-rate savings delivered over 2016 and 2017. However, demonstrating the size of the task at hand, the restructuring will cost the company £500 million to carry out.
‘A traditionally heavily centralised control culture will be replaced by empowered businesses, in a simpler, leaner structure with much clearer accountabilities. This will foster quicker decision making throughout the organisation,’ – Rolls-Royce.
East has admitted that there is still ‘too much overlapping capacity’ in the business, and that its traditionally large corporate centre is bloated. The company currently operates under five divisions: Civil Aerospace, Defence Aerospace, Power Systems, Marine, and Nuclear - but this will be trimmed down to just three under the restructuring plan in order to ‘shift our centre of gravity much closer to our customers’ and make its new divisions ‘fully accountable for the delivery of their strategic and financial targets’ by unravelling responsibility that has usually been reserved for head office down to each unit.
Civil Aerospace will deal with the core business building and servicing aircraft engines, the Defence unit will absorb the marine and submarine activities, and the Power Systems division will take on Rolls-Royce’s civil nuclear work.
Unsurprisingly, the new structure is based on where the future growth is. Civil Aerospace is already at the heart of Rolls-Royce, which has spent £11 billion in research and development (R&D) since 2010, yielding new technologies (including six new types of engine) as well as modernised facilities. While the division has hit some major barriers in recent years, Rolls-Royce is currently undertaking the largest expansion of its engine production facilities in its history, aiming to produce 550 in 2018 before continuing toward a bigger target of 600 by the start of the next decade. Annual capacity grew to 500 engines last year from 355 in 2016, which in turn increased from just 150 back in 2010.
Growing capacity is integral as Rolls-Royce has orders for over 2700 engines to fit wide-body aircraft and business jets. Having secured 185 new orders last year to end 2017 with 2500 on its books, the amount of orders for engines seems to have accelerated markedly this year.
The Power Systems unit manufactures engines, propulsion systems and generators to the marine, land defence, power generation and industrial markets. The unit makes about two-thirds of its revenue from selling products to original equipment manufacturers (OEMs) with the other third coming from supplying services. It competes with companies like Caterpillar, General Electric, Manpowergroup and Cummins. Europe is the biggest market, accounting for 45% of sales, followed by the Americas (23%), Asia Pacific (15%) and China (12%).
Much of the units success comes down to the fact it has a short-cycle order book, high margins and converts cash at an impressive rate, and Rolls-Royce’s reputation for quality is demonstrated by the fact it may only have 5% market share by volumes, but 15% share by value.
Power Systems saw revenue, margins and profit all improve last year as spending and costs declined, and this year the company forecasts ‘high single-digit growth’ in revenue while maintaining stable margins. This will be driven by demand from the oil and gas sector in the US and China and the power generation sector. In the medium-term, revenue is anticipated to grow by 3% to 5% higher than underlying gross domestic product (GDP) each year, while margins rise to the ‘mid-teens’ from 11.3% in 2017.
‘An unacceptable level of customer disruption,’ – Rolls-Royce.
Many of the current challenges facing Rolls-Royce have stemmed from troubles with its Trent 100 engine designed for the Boeing 787 Dreamliner and its Trent 900 engines that power the Airbus A380, which collectively represent 19% of all Rolls-Royce engines currently operating in the market.
Both models have seen some of their parts burn out quicker than expected, forcing the company to funnel serious levels of resources to rectify the problems. The urgency is amplified by the fact that the planes are already in service but now grounded, and although work is underway the company doesn’t expect to have the issues with the Trent 900 resolved until a new turbine blade is made available in 2020, and problems with the Trent 1000 won’t be fully rectified until 2022.
This will obviously be costly for Rolls-Royce, with some analysts forecasting charges could eventually mount up to £1 billion. Charges amounted to £98 million in 2016 and cash flow took a £90 million knock, before charges swelled to £227 million last year when cash flow took a £170 million hit. The company had warned that charges would rise further this year to about £240 million, before announcing it would be closer to £340 million. However, it has implemented short-term cost cuts, separate to the wider restructuring, to offset the additional £100 million of charges, keeping it on course to hit its wider financial targets. Prior to the discovery of the extra costs, Rolls-Royce had said costs would peak in 2018 and fall in 2019.
Importantly, the engine issues have also placed pressure on its engine production facilities that are already being held back by capacity constraints. For example, it trebled maintenance capacity to handle the issue, and used valuable production facilities to roll-out replacement parts – all capacity that could have been utilised to boost output of new, in-demand engines.
Longer-term, it has dampened any potential for Rolls-Royce to expand into the narrow-bodied aircraft market which it has been linked with for several years, where it has lost out to companies like General Electric. With aircrafts carrying long lifecycles, Rolls-Royce will be keen not to miss out on any further next generation aircraft that are developed, and will want to ensure they have the ability and the reputation to take advantage of new opportunities that will come in the near future.
‘We have made progress in improving our day-to-day operations and strengthening our leadership, and are now turning to reduce the complexity that often slows us down and leads to duplication of effort. It is never an easy decision to reduce our workforce, but we must create a commercial organisation that is as world-leading as our technologies. To do this we are fundamentally changing how we work,’ – Warren East.
While striving to be a ‘simpler, leaner and more agile’ organisation sounds good on paper, this also means a swathe of job cuts, most of which will be made to its UK workforce. About 4600 roles are to go – and quickly – with about one-third of those cuts expected to be made by the end of 2018 and the rest completed by the end of 2019.
The job losses represent about 9% of the company’s 50,000-strong global workforce. But as two-thirds of the cuts will occur in the UK, where Rolls-Royce claims to be responsible for one in every 250 jobs, the engineer intends to cut over 3000 jobs in the country alone – nearly 14% of its UK employees.
The bulk of the cuts will be made to those providing functional support, shrinking its headcount to 25,400 from 28,400, with its corporate centre (including head office and business service staff) falling from 4300 to 2700. Its head office will be half of its current size.
Rolls-Royce has been keen to stress that it is cutting corporate roles, not skilled workers like the engineers that are at the centre of the business, in order to rid itself of ‘complexity and duplication’ – a fair argument considering each department has its own human resource, legal, communications and legal teams. Alvarez & Marsal, turnaround specialists that East brought in earlier this year, has encouraged the job cuts as well as moves toward automating the business and adopting zero-based budgeting, whereby the company has to justify everything it spends each year.
Rolls-Royce’s UK operations consists of 30 sites that account for 45% of its global workforce, with 22,300 people – 9000 of which are engineers. Currently, 40% of the UK workforce is made up of engineers, with non-manufacturing roles making up the other 60%. However, after the job cuts are made, this will level out more evenly to roughly 47% engineers to 53% non-manufacturing staff.
The company’s UK staff are heavily concentrated in Derby, where its head office has stood proudly at the centre of the business for well over a century. There are over 12,000 staff at the Derby site, and this is where many of the job cuts are expected to be made. According to DerbyshireLive, the online edition of local newspaper the Derby Telegraph, around 1000 workers will leave this year, with another 1000 to go by mid-2020 – implying that two-thirds of the cuts being made in the UK will be made at its historic head office.
Key UK facility
Facility type and activity
|Derby||UK Academy base, focus on aerospace and submarines||12,000|
|Bristol||Principal defence site, focus on aeropsace and naval||3000|
|Derby Raynesway||Specialist nuclear activities, making nuclear reactor cores||2400|
|Birmingham||Critical controls for aerospace, industrial, marine||1100|
|Inchinnan||Aerofoils, engine shafts, discontinued engines||820|
|Hucknall||Components for gas turbines, defence, aerospace, marine||800|
|Washington||Specialist site for aerospace fan and turbine discs||100|
|Rotherham||Advanced Blade Casting Facility making crystal turbne blades||100|
Many politicians have come out to criticise Rolls-Royce, a company that made £4.9 billion profit last year, and its plan to cut thousands of jobs, with Derby South MP Margaret Beckett describing it as ‘too deep, too fast’. But that is still not an objection, and considering the growing list of towns that have collapsed or nearly faltered in the wake of a single company’s decision (like Tata Steel in Port Talbot), the government’s acceptance will come under scrutiny.
So why has Rolls-Royce managed to announce such heavy job losses without any repercussions? Firstly, the investment it has made into its UK facilities has won it favour. Secondly, Business Secretary Greg Clark has been convinced that Rolls-Royce may be cutting corporate workers, but plans to continue recruiting more engineers, technicians and apprentices.
For example, Rolls-Royce had to strike a deal with trade unions in order to push ahead with its new civil aerospace facilities, spending £150 million last year on new sites in Washington and Rotherham, and it has promised to ‘honour previous commitments for no compulsory redundancies of represented staff’.
As far as Rolls-Royce and the government are concerned, the plans are not part of shrinking to survive but to place a company that is so important for the UK on the international stage in a better position to compete, freeing up vital cash to invest in future technologies. Still, that will be hard to swallow for workers in Derby, who will also question Clark’s vow to ensure the ‘interests of the workforce are strongly represented’.
‘We are coming out of a significant investment cycle and are poised to deliver much improved returns. To achieve this we must focus on reducing further the original equipment cash deficit per engine, increasing our aftermarket cash margins and 'bending the fixed cost curve' by focusing on R&D, capital expenditure and commercial and administration costs. The restructuring programme is a key enabler to delivering reductions in our fixed costs while allowing our businesses to be more accountable for their own costs,’ – Rolls-Royce chief financial officer Stephen Daintith.
Restructuring Rolls-Royce goes far beyond cutting out costs and streamlining the business. While the company is working toward several ambitions, the job over the medium-term is to improve cash flow while addressing its costs, maximising cash not only for investments but also the likes of shareholder returns.
Fixed and investment costs hit a record high in 2017 of over £3 billion, but the company’s plan aims to reduce these costs by around £500 million (about 16%) on an annual basis, reducing the costs down as a percentage of sales from 23% down to 15%:
|2017||% of sales||Ambition|
|Commercial & Admin costs||£1124||8%||5%|
|Net R&D/ certification & participation||£1195||9%||6%|
Rolls-Royce generated just £273 million of free cash flow last year, but aims to have breached the £1 billion mark by 2020, with the hope of doubling that over the medium term. On a per share basis, it is aiming to generate £1 of free cash flow per share each year. Based on last year’s figures, that would be a staggering jump from 2017’s result of 14.9p. It also hopes to raise the cash return from invested capital (CROIC) to 15% through the cycle. CROIC fell to a low of just 9% last year from 11% in 2016, following consistent declines since at least 2013, when CROIC was 17%.
Importantly, the costs of the restructuring will not be included in reported cash flow figures.
But to deliver such growth Rolls-Royce is having to reshape itself from top to bottom, for great rewards. In the next few years it expects to be powering over half of the world’s wide-body passenger planes, having only accounted for 22% ten years ago.
As well as handing more responsibility and power to its divisions, it is also striving to move production closer to their end markets, constructing facilities in big local markets. Attention is on China where it has a joint venture serving the power generation and oil and gas industries, and in India where it is predominantly targeting rail and power generation markets.
With that in mind, it is hard not to question the role of Brexit at a time when jobs are being cut in the UK and new facilities are being opened up abroad. Rolls-Royce accounts for 2% of all UK goods exported each year and over 80% of all its UK production is exported. The company has also said it aims to source components from lower cost countries, in the hope of trimming £50,000 off the cost of each engine it makes, and strike closer supplier partnerships – just two ways it is aiming to cut the cost of producing each engine by hundreds of thousands of pounds.
Read more about what a global trade war means for steelmakers and miners
Rolls-Royce may be known for its engines and products, but revenue is almost equally split between manufacturing equipment and providing services, with each generating roughly £7.5 billion in sales last year.
In fact, Rolls-Royce made a loss of about £1.6 million on every wide-body engine it sold in 2017 – and that will continue for years. By 2022, it expects to still be losing money on selling wide-body engines, about £400,000 per one. That improvement alone is expected to drive £500 million of additional annual cash flow. This means maximising the already higher-margin service business is more important than ever for Rolls-Royce.
Many of the services it provides is on the equipment it has sold. Rolls-Royce aims to push for more ‘life cycle’ agreements that are longer-term deals, utilising ever-improving digital capabilities. Demonstrating it is still hiring, it plans to double the size of its existing team providing life cycle services to its customers.
This feeds into the company’s plans to become a ‘solution provider’, which will expand its proposition to lock in customers with more services. Automation and electrification are the two main areas where Rolls-Royce sees growth in this respect, and the firm is building up its capabilities as a result.
Altogether, the ambitious growth that Rolls-Royce is chasing comes down to selling more engines at smaller losses, and selling more services at a higher margin. Rolls-Royce reported a cash margin of £1.3 billion for providing aftermarket services on over 4400 wide-body aircraft last year, but hopes to lift this to over £2 billion by 2022 when it aims to be serving 6500 active engines on the market, adding another £750 million to annual cash flow.
The Power Systems unit generated record high revenue and margins in 2017 and the division is expected to continue growing over the coming years. Securing longer service agreements and providing a more integrated offering will play a significant role in helping to maximise the potential.
|Average sales growth % above global GDP||-||3%-5%|
|Non-diesel production as % of total||5%||10%-15%|
|Production in Asia||less than 5%||15%-20%|
|OE/Services % split||66:34||60:40|
The next scheduled update from Rolls-Royce is due on 2 August, when it is expected to release its first-half results, covering the initial six months of 2018. Trading has remained on track so far, with Rolls-Royce aiming to deliver the following guidance this year:
|Civil Aerospace||£6.61 billion||High single-digit growth|
|Power Systems||£3.11 billion||High single-digit growth|
|Total||£13.68 billion||Mid-single digit growth|
|Underlying operating profit|
|Civil Aerospace||(£330 million)||
Losses to reduce by one-third
|Defence||£451 million||Margins down by 250bps|
|Power Systems||£319 million||Stable margins|
|Total||£321 million||£400 million (£300-£500 million)|
|Free cash flow||£273 million||£450 million (£350-£550 million)|
Rolls-Royce shares have narrowly missed out on breaking out past highs that have not been seen since early November last year. Still, there is a long way to go for Rolls-Royce shares before they return over the £10 per share mark, which it has not traded at since May 2015 when East took over.
IGA, may distribute information/research produced by its respective foreign marketing partners within the IG Group of companies pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Where the research is distributed in Singapore to a person who is not an Accredited Investor, Expert Investor or an Institutional Investor, IGA accepts legal responsibility for the contents of the report to such persons only to the extent required by law. Singapore recipients should contact IGA at 6390 5118 for matters arising from, or in connection with the information distributed.
This information/research prepared by IGA or IG Group is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person. You should take into account your specific investment objectives, financial situation or particular needs before making a commitment to trade, including seeking advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. In addition to the disclaimer above, the information does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. Any views and opinions expressed may be changed without an update.
See important Research Disclaimer.