Commentary and analysis from Howard Wheeldon FRAeS on the announcement from Rolls-Royce on their first half results.

In announcing the first half results for 2017 I consider that the opening and secondary comments made by Rolls-Royce CEO Warren East provide more than sufficient guidance that the long and difficult period of transition work to improve performance is working. Let no one be under any misapprehension of the extent of the work required to position Rolls-Royce in the globally competitive position that it seeks to be. What is evident within these results is only the start of a process that will take several years to complete. But the evidence shown today is very positive of what can and will in my view be achieved over the next two and three years. The clarity and transparency with which the first half results have been displayed is also very welcome. As I say, no one should be under any illusion that there is still a long way to go yet but neither should they ignore the evidence of strong signs of progress within these first half results:

“Rolls-Royce delivered encouraging year-on-year operational progress in the first six months of the year. Civil Aerospace large engine deliveries increased 27% and we made good further progress improving Trent XWB OE economics. Restructuring savings were ahead of plan. Together with a higher than expected benefit from long-term contract accounting adjustments, this resulted in a good set of results, with financial performance ahead of our expectations for the first half. Looking to the balance of the year, execution and delivery of several important milestones across our businesses will be key to achieving our full year expectations. Our outlook for full year profit and cash remains unchanged.”

“Two years ago, we set out a programme of change at Rolls-Royce to drive efficiency and sharpen our focus on execution. Our strengthened management team is making good progress in simplifying the organisation and driving the pace of necessary change to develop a more resilient and sustainable business. However, this is no time for complacency. Strong execution and a focus on delivering our customer commitments remains essential as we continue to manage in-service issues in Civil Aerospace alongside key new product introductions and increased production volumes. Our long-held commitment of investing in R&D and future technologies remains unchanged, as we look to secure the long-term success of the business, built on a solid platform of outstanding customer service and strong cash flows.”

In brief, first half revenue rose 6% to £6.78 billion and the company disclosed underlying profits being up by close to 150% - from £104 million to £287 million. In respect of divisional performance, the company has stated that profits have improved in Civil Aerospace (£173 million v £31 million in 2016) and Power Systems (profits of £66 million v £13 million in 2016), remained steady in Defence (profit before financing of £148 million v £128 million in 2016) and that Marine activities, with profits of just £14 million, continue to suffer challenges that are related to the weak offshore oil and gas market. Profits in Nuclear fell by £4 million to £14 million reflecting changes in product mix although full year guidance remains unchanged.

Importantly, Research and Development spend has increased to £411 million, Commercial and Administration costs have fallen by 7% to £38 million and the Interim Dividend is maintained at 4.60p per share. The order book at the end of H1 stood at £82.7 billion (£H1 2016 - £81.3 bn). Operating Margins rose by 220 basis points to 5% for the period. There was a significant improvement in the balance sheet with net assets of £3.2 billion (2016 £1.86 bn). Free cash flow was (£339 million) against a H1 2016 result of (£342 million). Closing net funds (borrowing) stood at £931 million against a previous year figure of £712 million.     

Currencies

Since the end of 2016, the value of sterling relative to the US dollar strengthened by around 5% to the end of the first half, compared to the prior period in which sterling depreciated by around 10%. As a result, the company has recognised a net £1.4bn non-cash mark-to-market favourable valuation adjustment for all our derivative contracts (2016: £2.2bn charge). The valuation adjustment was the principal reason for the reported financing gain of £1,470m against a 2016 charge of (£2,386 million) and reported profit before tax being £1,941m (2016: Loss of £2,150m).   

Free Cash Flow

Free cash flow improved by 18% to £339m (2016: outflow of £414m) during H1, this was better than expected and reflects a steady operating performance, supported by a higher level of working capital management (by around £180m) and which was the significant contributor to the year-on-year improvement.

Forward Focus

The priorities of intended change to sustain the transformation process at Rolls-Royce are built around strengthening focus on engineering, operational and aftermarket excellence to drive long-term profitable growth and to rebuild lost trust and confidence of key stakeholders. Steady progress has been achieved in all objectives. Importantly, along with rebuilding trust and improving communications, the company is on track to deliver planned 2017 and 2018 transformation benefits. The addition of Simon Kirby as the newly appointed Chief Operating Officer and Stephen Daintith as Chief Financial Officer over the past six months together with the appointment of Chief Technology Officer, Paul Stein complete the management changes planned last year. Their work in part will also be to embed the range of Key Performance Indicators established through the transformation process and that are built around cost savings, working capital reductions and the cash drivers of the business and to embed these not just throughout the company but also within the external reporting focus to demonstrate the value of wider financial and non-financial performance improvement.

IFRS 15 – Revenue from Contracts and Customers (New Standard from 2018)      

As highlighted in 2016, the introduction of the new revenue reporting standard, IFRS 15 Revenue from Contracts with Customers, in January 2018 will have a significant impact on how the company presents revenues and profits, particularly those covering Civil Aerospace. In November 2016, RR provided a detailed representation of its 2015 financial results for Civil Aerospace and they have repeated a similar analysis for 2016. Clearly, the impact of the new revenue reporting standard will have significant impact on the company but it has been well flagged and well communicated.  

Pension Fund

A statutory funding valuation currently being conducted as at 31 March 2017 is expected to show material surplus. No deficit funding is anticipated and the new contribution schedule is expected to take effect from 2018.

CEO 2017 Outlook Statement

Our overall outlook for 2017 is unchanged from that set out in February 2017. While we have had an encouraging start, we have a great deal of work to do to deliver our overall expectations for the year. Key deliverables in the second half of the year include our Civil Aerospace delivery ramp up, new product introductions and managing installed fleet performance. While the outlook for Power Systems appears more positive, our Marine business remains challenged. As a result, we remain cautiously optimistic for the year as a whole.

CEO - Long-term outlook remains strong

 “We continue to see value in the underlying strengths of our business: the underlying growth of our long-term markets, the quality of our mission-critical technology and services, and strength of customer demand for these which are reflected in our substantial order book. While we have near-term challenges and some key execution priorities, these constants provide us with confidence in a strong, profitable and cash-generative future”.

“The progressive roll-out of new engines, led in particular by the Trent XWB, 1000 TEN and 7000, together with a growing aftermarket, is expected to drive significant revenue growth over the next ten years as we build toward a 50%-plus share of the in-service widebody passenger aircraft market”.

“As a result, we remain confident that the important investments we are making to transition our production will create a resilient platform from which to drive customer service and strong cash flows, together with the current investments in new products and the streamlining of our existing product portfolios across the group to ensure we are providing high value, cost-competitive products into our target end markets”.

Final CHW Comment

Given the flurry of comment over the weekend in relation to the commitment to achieve £1 billion free cash flow in three years it is right that the company should warn of potential risks of unforeseen events that could push the projected timeline out further.

What the company have disclosed in its 2017 H1 results today boil down to signs of excellent progress being made in what was always going to be a minim three-year transition exercise. There is a very long way to go yet but it is pleasing that things are headed very much in the right direction. The fundamental strengths of the business remain very sound and the company remains on course to achieve 50% of the global wide body engine market in about three years’ time. We need also to remember that in this business there are very high barriers to entry.

As ever, in the civil aerospace engine market profits come from the incremental revenue stream of engines in service rather than in their manufacture. In the various ‘Power by the Hour’ together with SelectCare™, TotalCare®, Flex® and LessorCare™ range of fixed cost through life support packages for airline customers Rolls-Royce has not only positioned itself very well for the future but also got closer to the customer.   

I will end with a response comment I found in respect to comments made about Rolls-Royce impending results and concerns in respect of free cash flow commitment over this past weekend and with which I absolutely concur:

“Warren East is a truly outstanding CEO and it's typical of him to be concerned not to allow investors to get ahead of themselves. The correct reaction to this news would be to have increased confidence in the direction of travel whilst being cautious about what numbers are put into spreadsheets”.

This is a global company that we in the UK should all be very proud. Yes, it has made mistakes and yes, it is going through huge period of transition and change but with the world leading technology that it has all that I can say is that in the post Brexit world, we need Rolls-Royce to be strong, efficient and globally competitive. I have no doubt at all that this is exactly what Warren East and his team will achieve.

Howard Wheeldon FRAeS
1 August 2017

Comment title