Rolls-Royce Holdings plc 2014 Full-Year Results

Group Highlights

Record order book £73.7 billion
Underlying revenue and profit in line with guidance1
Free cash flow £254 million (£447 million excluding the divested Energy business)
Reported profit before tax £67 million2
Concluded the sale of the Energy business and began a £1 billion share buyback with the proceeds
Delivered the first Trent XWB engines for launch customer Qatar Airways
Secured an exclusive position to power the Airbus A330neo
Launched new family of medium-speed reciprocating engines
Payment to shareholders 23.1 pence per share, up 5%
Rolls-Royce Holdings plc
£ millions 2013 2014 Change
Order book 71,612 73,674 3%
Underlying revenue 15,505 14,588 -6%
Underlying profit before tax 1,759 1,617 -8%
Return on sales* 11.8% 11.5% -0.3pp
Underlying earnings per share 65.6p 65.3p -0.3pp
Full year payment to shareholders 22.0p 23.1p 5%
Reported revenue** 14,642 13,736 -6%
Reported profit before tax** 1,700 67 -96%
Reported earnings per share** 73.3p 3.7p -95%
Net cash 1,939 666 -66%
Free cash flow*** 781 254 -67%

John Rishton, Chief Executive, said:

“We have met guidance for 2014 revenue and profit in challenging conditions while continuing to build strong foundations for future growth.

“2014 has been a mixed year during which underlying revenue fell for the first time in a decade, reflecting reduced spending by our defence customers, macroeconomic uncertainty, and falling commodity prices. In response to these headwinds, we are taking decisive action to improve the Group’s financial performance and accelerating our focus on the 4Cs: Customer, Concentration, Cost and Cash. This includes a major restructuring programme in our Aerospace Division and continued rationalisation of our Land & Sea Division.

“The fundamentals of our business remain solid, with long-term growth in demand for the complex power systems we deliver across our Aerospace and Land & Sea Divisions.

“In Aerospace, the delivery of the first Airbus A350XWB, powered by the Rolls-Royce Trent XWB engine, marked a significant milestone in our most important programme. In Land & Sea, we introduced a new family of medium-speed reciprocating engines.

“Our record order book demonstrates the faith our customers continue to place in our technology and underpins our confidence in future growth.”

Group Overview

The Group order book increased 5% to £73.7 billion. Free cash flow declined 43% to £447 million, primarily reflecting lower volumes, as well as lower deposits in Civil, Marine, and Defence.

In August, we completed our acquisition of Power Systems, purchasing Daimler’s 50% share in the company for £1.94 billion. Power Systems has world-leading technology in high-speed reciprocating engines and advanced fuel injection systems, and extends the scale and scope of our Land & Sea Division.

Rolls-Royce operates as two Divisions: Aerospace and Land & Sea. We believe both markets offer attractive returns and leverage our core strengths. There is an industrial, commercial, and strategic logic that ties our Aerospace and Land & Sea Divisions together and generates value for the Group.

Industrially, our knowledge of advanced engineering applies across both Divisions. World-class technology is required by all of our customers and, as the power systems we produce become more sophisticated, a deep understanding of materials science, electronics, data management, and aftermarket services are increasingly important in every part of the Group.

Commercially, the need for scale and portfolio breadth with exposure to differing business and investment cycles is something that both we and our competitors recognize. This scale provides a balance sheet that can withstand shocks, and in turn, provides confidence to our customers who are buying products that will be in service for decades. Our breadth increases market access and generates opportunity.

Strategically, our two Divisions address growing markets. Strong growth in the demand for air travel is widely forecast and is reflected in our £63 billion Civil aerospace order book. Future growth in world trade (90% of which is carried by sea), urbanisation, population growth, and tighter environmental regulation leaves our Land & Sea Division well-positioned to meet the increasing requirements for cleaner power.

Operations

We continue to focus the Group on the 4Cs of Customer, Concentration, Cost, and Cash.

On Customer: We continue to make good progress improving quality, delivery, reliability, and responsiveness – the characteristics our customers tell us they value most. The results can be seen across a wide range of programmes.

In Aerospace, the Trent 1000-powered Boeing 787 Dreamliner has achieved an industry-leading 99.9% engine dispatch reliability after more than 500,000 flying hours in service. Since launch, we have doubled the time on wing for both our Trent 700 and Trent 800 fleets. In our Corporate & Regional business, we achieved a 57 percentage point improvement in our response time to business jet customers.

In our Land & Sea Division, on-time delivery to Marine customers has improved by 33 percentage points since 2012. Marine also signed its first commercial long-term service agreement. As the power systems we deliver in Land & Sea become more complex, we see further opportunities to expand our aftermarket activities, building on the data and service capabilities we have developed in Aerospace. In Power Systems, we opened an additional logistics centre in Singapore, enabling a 5% improvement in the availability of spare parts and setting a new standard for customer service.

Recognising the progress we have made, Airbus has presented us with their Supply Chain and Quality Improvement Award. The US Government’s Defense Logistics Agency recognised Rolls-Royce as a ‘first tier supplier’ from amongst 153 companies, and we were awarded joint first place by Aviation International News for the quality of our business aircraft support. Improving performance in this way deepens the relationship we have with our customers and generates opportunities for us to secure additional business.

In major programmes:

In July, we announced the seventh member of the Trent engine family, the Trent 7000, which will power the new Airbus A330neo. This new engine will incorporate technology from our most recent Trents, and will deliver a 10% improvement in fuel consumption while halving noise energy compared to current aircraft. We will be the exclusive engine supplier on the A330neo, which is expected to enter service in 2017.

In December, we were delighted to celebrate the first customer delivery of the Trent XWB to launch customer Qatar Airways. The Trent XWB is the most fuel-efficient large aero engine operating in the world today. We continue to be the sole engine provider for the Airbus A350 XWB.

In our Land & Sea Division we continue to bring new technology to market. In September, we unveiled our new medium-speed, Bergen B33:45 engines, which offer a 20% increase in power per cylinder while reducing fuel consumption, emissions, and operating costs.

In July, we celebrated the naming of the Royal Navy’s newest aircraft carrier, the HMS Queen Elizabeth. This represented a major milestone for our Marine business that has supplied the engines, propellers, rudders, and steering gear for this highly-advanced and complex vessel.

On Concentration: The completion of our Power Systems acquisition has added significantly to the breadth and reach of our Land & Sea Division. We are already seeing the benefits of this acquisition, where our MTU diesel-electric propulsion systems were delivered to Marine customers for offshore vessels in China and Brazil.

The sale of our Energy business to Siemens demonstrates our continued drive to focus our organisation where we can most add value. The sale proceeds of around £1 billion are being returned to shareholders by way of the share buyback programme we initiated in December.

On Cost: We have taken action to improve cost performance in every part of the business and in every cost category. We have made good progress in some areas and as a result, Group gross margins improved by 1.7 percentage points in 2014. In Defence, we have improved margins despite declining revenue. In Land & Sea, we closed five plants and are rationalising other parts of the business. For example, we are consolidating production of steering gear in Norway and waterjets into Finland. We are driving down cost by improving quality, simplifying logistics, reducing waste, and adopting processes that allow us to make things better and faster.

In November, we announced a restructuring programme in our Aerospace Division and central functions, which is expected to reduce headcount by 2,600. By the end of 2014, 545 people had left the business, with the majority of the reductions expected in 2015. This programme is expected to result in restructuring charges of around £120 million, of which £56 million was recognised in our 2014 results. We anticipate annualised cost benefits of around £80 million from 2016 onwards, with £50 million in benefits expected in 2015. Our total Aerospace 2014 restructuring activities cost £164 million (of which £139 million was underlying).

However, in a complex and highly-regulated business, we recognise that it will take some time for the full benefit of our cost programmes to feed through. There are also a number of headwinds in our Civil aerospace business associated with our future growth. For example, we have invested in the capacity required to deliver our record order book, but delay in a number of our customers’ major programmes has meant some of this new capacity has come on stream before it is needed, leaving us with under-utilised production facilities. We have also constructed a number of new world-class facilities to replace older, less productive plants. For a period of transition we are carrying the cost of both the old and new facilities.

Group restructuring costs in 2014 were £188 million, of which £149 million was underlying. Over the past two years, the Group has reduced indirect headcount by 18%. We expect Group underlying restructuring costs to be between £90 and £100 million in 2015.

Cost performance will continue to be a major focus, and as we rationalise and transform the Group, we have targeted a 20% reduction in our footprint and a doubling of our lower-cost country sourcing by 2020. We are now accelerating progress towards these targets.

On Cash: Our free cash flow was lower in 2014 than in 2013, primarily reflecting lower volume, as well as lower deposits in Civil, Defence and Marine, and the expected increase in the TotalCare receivable. Inventory declined from £3.3 to £2.8 billion during the year, primarily reflecting the Energy sale and foreign exchange. Excluding this, inventories improved by £140 million and inventory turns were flat on lower volume. We continue to focus on improving our free cash flow, particularly in the face of near-term headwinds. Our programmes to reduce product and aftermarket costs, to lower our headcount, and to reduce our footprint all require upfront investment, but will deliver cost and cash benefits in the medium-term. As revenue increases, we expect to reduce our capital expenditure and R&D as a percentage of sales. The customer progress highlighted above is improving our operational performance. Combined with increasing volumes, this will enable us to reduce our inventory buffers.

Order Book

The order book grew 5% to £73.7 billion, with increases in Civil aerospace, Defence aerospace and Power Systems. The order intake of £19.0 billion included net orders of £11.7 billion in Civil aerospace, £2.5 billion in Defence aerospace, £1.8 billion in Marine, £0.6 billion in Nuclear, and £2.6 billion in Power Systems. Our order book remains widely spread around the world, with 44% in Asia and the Middle East, 25% in North America, 25% in Europe, while South America and Rest of World account for 4% and 2%, respectively.
Income Statement

Group underlying revenue fell 5% to £13.9 billion. Excluding adverse foreign exchange translation, underlying revenue fell 2%. The main factors were a sharp decline in Defence aerospace OE revenue due to lower volumes as government defence spending in many countries was scaled back, and lower Land & Sea revenue due to weaker end markets. These falls were partially offset by continuing growth in Civil aerospace deliveries as Trent 1000 engine production ramped up, and an improvement in Defence aerospace services.
Group underlying profit before tax in 2014 declined 4% to £1,620 million. We saw a negative impact from lower volumes, especially in Defence and Land & Sea, increased R&D investment (£140m) and higher restructuring charges (£100 million), the one-off Marine charge (£30 million), and adverse foreign exchange (£49 million). These factors were offset by an improved trading margin which included an approximately £150 million benefit from improved retrospective TotalCare contract profitability (approximately £110 million negative in 2013), reflecting lower cost, changing operating patterns and reduced contract risk. Lower bonus and share incentive costs resulted in a saving of £178 million, about half of which was in commercial and administrative costs (C&A). Trading margins in Defence also improved, driven by both cost reduction action and an improved mix. In Land & Sea we had a difficult year at our Bergen subsidiary, reflecting weaker trading performance.
Research & development net spend increased in 2014 to £819 million, reflecting increased spending on the higher thrust Trent XWB-97k, due to enter service in 2017, and on the Trent 1000-TEN, due to enter service in 2016. We continue to invest in research for our Advance and UltraFan programmes, which will create opportunities for the next generation of gas turbine engines.
The Group provides both reported and underlying figures. Underlying figures exclude the impact of mark-to-market adjustments in our hedge book, post-retirement financing, and the effects of acquisition accounting. Reported profit before tax declined £1.6 billion, primarily reflecting changes in the foreign currency spot rates, which caused a mark-to-market change in our hedge book. Mark-to-market adjustments have no effect on cash flow, and are principally driven by movements in the £/$ exchange rate, which moved from $/£1.65 to $/£1.56.
Balance Sheet

The Group remains committed to maintaining a strong balance sheet and a strong, investment-grade credit rating. Standard & Poor’s retains a rating of A/stable, and Moody’s a rating of A3/stable. These ratings are important when selling products that will be in service for decades.
The Group holds £666 million in net cash and £3.5 billion in facilities. Debt maturities remain well-spread through 2026.
On 10 December, the Group initiated its £1 billion share buyback, which will return to shareholders the proceeds from the sale of the Energy business. As of 9 February, we had completed £204 million and purchased 23.6 million shares as part of the share repurchase programme.
UK pension liabilities, which represent approximately 86% of the Group’s liabilities, reported a surplus of £1.7 billion. Overseas, our net liability was valued at £1.2 billion. Overall funding across the schemes has improved in recent years as the Group has adopted a lower risk investment strategy that enables the funding to remain relatively stable.
The Group hedges transactional foreign exchange exposures to reduce volatility. The most significant exposure is the net US dollar income of approximately $5 billion per year which is converted into GBP. The hedge book was $26 billion at year end, which represents four and a half years of cover. The average rate was $/£1.61.
TotalCare Net Assets increased £463 million in 2014, consistent with our guidance. This will continue to grow as linked engine deliveries rise, reflecting the timing difference between profit and cash.
The Group’s net cash balance reduced from £1.94 billion to £666 million, reflecting the acquisition of the remaining 50% of Power Systems from Daimler, offset by the proceeds of the disposal of the Energy business.
Free Cash Flow

Free cash flow was £447 million compared to £778 million in 2014. Higher cash flow from operations and lower capital spending were offset by an increase in net working capital, which reflected lower customer advances or deposits, and the expected increase in TotalCare receivables.
Capital expenditure in 2014 was £649 million as we invested in facilities and equipment to deliver the large increases in widebody engines. This included investments in assembly and test facilities, our Advanced Blade Casting Facility in Rotherham and our Washington fan disc facility.
The cash cost of the pension programme in excess of the earnings charge was £54 million higher than in 2013.
2015 Guidance

Since we last gave guidance, the external environment has deteriorated in some of our major markets. In particular, oil prices have halved over this period, creating increased uncertainty for many of our markets and customers, particularly in Marine Offshore. As a consequence, our full-year guidance is framed within a broad range and excludes the effects of foreign currency translation. For the full year 2015, we expect:

At a Group level, we expect our earnings to be weighted towards the second half of the year, as in 2014, reflecting underlying trading, where our Civil and Land & Sea businesses are traditionally second-half weighted. Incremental to 2014, there will be a weighting of the R&D charge towards the first half and Civil deliveries are expected to be biased towards the second half. Despite the lower profit outlook, earnings per share will benefit from a reduction in the equity base due to the completion of the £1 billion share buyback programme, currently underway.

We continue to expect near-term headwinds on cash as we invest in the doubling of Trent engine deliveries and the transformation of the business. Full-year free cash flow in 2015 is expected to be impacted by the cash costs of the restructuring programmes and higher working capital as engine volumes ramp up, particularly for programmes in the launch phase. There will be a first-half bias in the cash cost of our restructuring efforts; we expect the benefits of restructuring to begin to be seen later in the year. We therefore also expect free cash flow to be more biased towards the second half than in 2014.

Across our two Divisions, we expect:

In Aerospace we expect continued volume growth in Civil to be offset by adverse mix effects due to launch pricing and a higher proportion of sales accounted for on an unlinked basis. Cost reduction activity will continue across our supply chain, operational footprint, indirect headcount, and service provision, which will continue to produce operational benefits. Retrospective TotalCare profit benefits are not expected to repeat at the same levels as in 2014.
In Power Systems we expect growth in the industrial, power generation and commercial marine end markets, offset by lower revenue from naval marine. On profit, we continue to focus on cost reduction, but face headwinds on mix. We are taking actions to improve the operating performance and cost controls at Bergen that are expected to restore profitability during 2015.
In Marine we anticipate that the market will remain challenging in the short-term, reflecting external factors especially oil price uncertainty, particularly in Offshore. We will accelerate our cost reduction focus on our footprint, our supply chain, and our overhead costs in order to drive a more competitive business while also adapting to volume risks.
We expect capital expenditure (additions to property, plant & equipment) to be around £600 million in 2015, down from £649 million in 2014. In 2014 capital expenditure was 4.7% of revenue. Over time we expect capital expenditure to trend towards 4%.
We expect net research & development (R&D) spend to be around £750 million in 2015, down from £819m in 2014. In 2014 R&D was 5.9% of revenue. We expect it to ease as a percentage of revenue as the business grows.
We expect a tax rate of around 24% in 2015, similar to that of 2014.
We remain confident in the fundamental strength of the business and its potential to significantly increase profit and free cash flow in the future.