UK: Financial Headwinds

Last Updated: 6 April 2016
Article by ICSA  

To issue just one or two profit warnings is worrying enough, but when a company issues five profit warnings within the space just of two years, it clearly has some problems. It is significant that this company is Rolls-Royce, a global blue chip player in the aero-engine market. Since 2014, the company has lost substantial shareholder value; its dividends have been slashed and its production cost base has remained too high for too long. Parts of its business may now be sold-off too. There have been suggestions that sectors of this engineering group may be forced into an arranged corporate marriage with a competitor. Rolls-Royce's 2015 preliminary results might have been marginally better than some analysts expected, but there remain unresolved financial troubles that have been made worse by poor strategic decisions.

Rolls-Royce's 2015 results show that underlying pre-tax earnings fell to £1.43 billion (from £1.62 billion in 2014). However, Warren East, the current CEO, has already sounded the alarm bells in the company's interim management statement last November. The 2015 full-year preliminary results confirmed that the CEO's earlier pessimism was entirely justified – with more bad news to come. The projections for 2016 now suggest that underlying net profit trading numbers are expected to be hit with further 'headwinds' that will remove another £650 million from the company's results during the coming financial year.

Failing sectors

Rolls-Royce does not just manufacture aero-engines – although this sector does generate around two thirds of the company's revenue. Under IAS14, 'Segmental reporting', listed companies are required to show the amount of revenue and profits arising from each business sector. Although for many companies segmental reporting has limited value, for Rolls-Royce the information is more useful. It shows that the company's marine sector has suffered a year-on-year 23% reduction in revenue with gross profit falling by nearly 40%. In addition, revenue and gross profits for its power systems sector have also fallen and have largely stagnated in its nuclear sector.

In its 2015 results, Rolls-Royce unfortunately appears a little over-keen to highlight its more favourable 'underlying' results − which exclude 'one-off' items such as mark-to-market losses on derivatives, restructuring costs and from impairments. However, the fully-inclusive and consolidated income statement for 2015 more comprehensively shows the overall extent of just how poorly Rolls-Royce has performed. The full financial statements, that include all one-off items (and make no exclusions), show that on total group turnover of £13.7 billion, Rolls-Royce achieves just £84 million in net profit. In addition, the key cashflow numbers arising from operating activities has fallen year-on-year by over 15% to £1.09 billion; with free cashflow now a mere £179 million. A disappointing performance by any measure – but many of these poor numbers have been brought about by the strategic direction of the company.

Management strategy

Ever since the late 1990s, under the previous leadership of Sir John Rose, the company decided, in terms of aircraft engines, that bigger is better. Rolls-Royce made the strategic decision to concentrate a high volume of its resources on manufacturing engines for large wide-bodied passenger aircraft. The company was convinced that this change of strategy would allow it to exploit future growth markets. As a result, Rolls-Royce soon came to dominate the global market for engines for these wide body aircraft. This included engines for the new longer distance Airbus and the Boeing 787 Dreamliner. At first, it appeared the management of Rolls-Royce had hit upon a winning strategy: its market share and earnings initially soared – but this success was to be short-lived.

Over the last few years, the major global airlines have quickly and radically re-thought their own business models. Many airlines are now switching back to the greater operational and marketing flexibility permitted by using narrow-bodied aircraft – a changing market that Rolls-Royce had largely overlooked. It was beginning to appear that the company had made a strategic error. The market had moved quickly but Rolls-Royce had not. Switching production back to concentrate on meeting the engine needs of the narrow-body aircraft market would now be costly and time consuming.

Rolls-Royce's main competitors, General Electric and Pratt & Whitney, had already seen that the market was undergoing change. These US rivals identified a sizeable mass market for their smaller engines and acted quickly, with the increased volume leading to substantial falls in their unit costs. The highly valuable after-sales engine maintenance and servicing of smaller, but more numerous, engines gave its competitors increased income. Rolls-Royce was soon trailing behind its global rivals.

Rolls-Royce's overall results were also hit particularly hard by the production of engines. The aero-engine division is the major revenue generator for the company, overshadowing other business divisions such as power systems, marine and nuclear sectors. As such, problems with the this sector had significantly greater impact upon the company's performance. Other external factors, such as increased global competition and defence cut-backs in overseas markets, have hit the engine sector and intensified Rolls-Royce's problems.

FRC investigation

Even before 2015, Rolls-Royce's accounting policies had come to the attention of the FRC. In particular, the company has relied heavily on providing after-sales engine servicing and maintenance. This after-sales provision frequently generated more income than the selling of engines. Customers could pay increased after-sales fees and Rolls-Royce would take on the responsibility of not just servicing the engines, but also bearing the cost of replacements if necessary. In 2013, the FRC intervened and asked Rolls-Royce to change its complex accounting policy that dealt with revenue-sharing agreements with partner-suppliers. Some analysts also believed that the company was accounting too aggressively for the income from after-care contracts and using them to engage in income reporting 'smoothing', i.e. to iron-out 'peaks and troughs' in reported earnings.

The FRC required Rolls-Royce to change its accounting policy for 'entry fees' that arose from these risk-sharing arrangements with partner-suppliers on engine development projects. The FRC was not satisfied with Rolls-Royce taking these fees to income immediately on payment, but instead it required changes so that the fees would have to be apportioned over a project's expected lifetime. The result was that nearly £40 million was then cut from the 2013 pre-tax profits.

Government concerns

Concern about Rolls-Royce's performance has come from another direction too. The UK Government is becoming worried about the company's financial problems impacting on its contracts. The concerns relate to whether the vital supply of engines to the country's Royal Navy nuclear submarines could be affected by Rolls-Royce's financial and operational problems. Analysts suggest that the Government has not ruled out recommending that Rolls-Royce seeks out a competitor to form a joint venture or perhaps sell some of its business sectors. There are even suggestions that, in the interests of national defence, the Government might consider nationalising the marine or nuclear business sectors. The UK Business Minister, Anna Soubry, is said to be 'monitoring the situation carefully'.

Expectation management

In some ways, the release of the disappointing 2015 results reflect a clear management of investors' expectations. Rolls-Royce lowered expectations and initially did nothing to dispel rumours that it would also issue another profit warning around the time of the publication of its results and cancel the final dividend distribution. Yet on publishing the final results, there was neither a profit warning nor a cancellation of the dividend. There was 'only' a 50% cut in the final dividend – which the market then received as being better news. Even so, this 50% reduction in the expected dividends will only conserve around £200 million in cash terms – hardly worth the damage to the company's reputation as it has not cut final dividends in nearly a quarter of a century.

Other measures to give an improved image and to prop-up the company's earnings per share were taken just over a year ago by the previous CEO, John Rishton, who supported a £1 billion share buyback. Unfortunately, after the shares were purchased, the market value then almost halved within the following year. The over-priced share buyback may have helped to support earnings per share indicators in the short term, but the cash out-flow has now further reduced the liquid resources available for the company and wasted further shareholder value.

Contingent liabilities

The 2015 preliminary results also warn that the Serious Fraud Office continues to investigate the company about 'allegations of malpractice in overseas markets.' Under IAS 37, Rolls-Royce discloses potentially worrying levels of contingent liabilities. The disclosure notes warn the outcomes could include prosecution of the company and individuals resulting in further 'fines, penalties or other consequences (which) could not currently be assessed.' In particular, the company is being investigated in the Far East and in South America about corruption allegations. Depending on the outcome, further costly reputational damage could be inflicted on the company.

More to come

There may well be another profit warning later in 2016 – if the company fails to implement major cost cutting and reduce unit costs, and turn its order book into higher cashflows and reported profits. Pressure on the company is already increasing from overseas. Shareholder activists in the US are seeking a seat on Rolls-Royce's board and a greater input into decision making. In addition, Rolls-Royce's financial position will probably mean that the company will be forced into re-capitalising its balance sheet. It may later need to raise at least another £1 billion to restructure the business and inject new capital.

The next couple of years will be critical to Rolls-Royce's future. The company has removed considerable share value over the last few years. Even though the company has had an enviable reputation as an engineering player in international markets, the company is a reminder that the success of any business cannot not be guaranteed.

John Stittle is a Senior Lecturer at the University of Essex

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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