Those that seek to knock Rolls-Royce now do so at their peril, says Howard Wheeldon.
Despite the political and economic ills that affect the UK economy, let alone that still hit many areas across the world where R-R operates. Despite the woes affecting the two really big commercial aircraft makers, Airbus and Boeing, not to mention others in the second tier and the extreme problems that have been hitting virtually every global airline one can think of. Despite the increasing reality of defence cuts in some of the markets served — with much talk of more. Despite the almost permanent state of uncertainty that governs decisions related to investment in big electrical energy, oil and gas projects and despite questionable levels of customer investment in some quarters of marine engineering, it seems that the turbine of Rolls-Royce profit growth continues to steam on seemingly unabated. The key is diverseness and, in my view, disciplined consistency of strategy.
Am I really surprised that RR FY09 revenues went up by well over £1bn to £10.4bn? No. Am I pleasantly surprised that the all-important figure of underlying profit for the year rose 4% to £915m in what many had thought would be the year that signalled the beginnings of a R-R downturn? Not a bit of it, although I am a somewhat surprised that others should be. Neither am I surprised that RR announced that excellent order intake during the year led to yet another record order backlog —totalling £58.3bn. And what of the statement contained in the report telling us that the financial position at R-R remains healthy; that average net cash for the period all but doubled over last year to £635m; that the year actually ended with net cash of £1.25bn and that as a consequence the balance sheet remains very strong? Again, no surprise to me, nor that the R-R board also decided to raise the full year dividend by 5% to a healthy 15p per share.
GKN apart, there is no UK company that as a specific aerospace, defence and industrials equity analyst I covered longer that Rolls-Royce. Despite the considerable respect I held for the company, it is certainly true that through the late 1980’s and 1990’s attempting to persuade existing or potential investors of its merits was rather like banging one’s head against a wall.
For years, if not the best part of two decades, there existed the belief that by investing significantly in research and development R-R’s long term future would be assured — not so much by specific order and build sales revenue related growth, but due to incremental revenue growth derived from the simple fact that increased engines in service would mean increased lifetime service, maintenance and parts revenue and profit. True, it took the best part of two full decades of R&D spend that short term investors so loathe to see before the benefits began to manifest. By then, of course, R-R financial reserves were necessarily stretched, leading to a band of short-term pessimists spreading rumours that the company would soon announce a big rights issue. What rubbish this was, and how right the small and loyal band of supporters — myself included — had been to dismiss such suggestions.
Today we may regard R-R not just as a survivor, but a phenomenally successful UK-based engineering company that is also a world leader in the fields of operation it covers. A truly diverse company it is, with a robust spread of industrial engineering activities through aero, defence, marine, industrial and energy related sectors. Whilst creating improved manufacturing efficiency has been a significant aspect of its profit improvement, perhaps more importantly — in term of the future development of profits, at any rate — was the sheer number of R-R engines in service. Rather simply, the more engines in service, the more that would eventually require maintenance and support. It is a process that, whilst having taken years to achieve, has undoubtedly worked, and reasons why I and many others believe that R-R will continue to provide sustainable profits growth while reducing development risk in the process.
R-R is an example of what is achievable within the constraints of a long term strategy that requires up-front cash and, perhaps, bizarre risk revenue sharing partnerships. Clearly, given the well broadcast global economic difficulties it would be wrong to expect that R-R can continue achieving the consistent profit and balance sheet improvements on the scale it has in recent year. For FY2010 we agree, therefore, with the sentiments expressed by the company in its report to shareholders that it may be best to assume the current year will be at worst flat and at best only a touch better than that. It remains easy to forget that despite the excellence of its 2009 performance, R-R has also suffered a variety of problems — particularly those of both Airbus and Boeing on projects such as the 787 Dreamliner, the A380 and, of course, the much delayed A400M military airlifter. Those troubles are set to continue into 2010, but the bottom line is that the situation is unlikely to get any worse. The potential of defence building cannot be ignored, although we doubt that there will be an overly significant impact from potential cuts in US or UK defence spend in 2010 or 2011. That said, we cannot ignore the relevance to R-R of the Joint Strike Fighter — of which the STOVL versions will use the RR ‘LiftSystem’. In Marine, RR tells us about the US Navy Littoral Combat Ship development, while reminding us that the Astute and Type 45 programs still have a long way to go.
From a low of 53p in December 2003 R-R shares are now almost back to the peak 521p achieved in July 2007. Clearly, 2010 represents a year in which R-R will need to run even harder than it has, but it will not stand still; of that we can be certain. Indeed, it is my hope that we will begin to see even more research and development, with strategic planning for where RR wants to be in 2020 and beyond. What stands out about this company, though, is that over the past two decades the story has been one of sheer disciplined consistency. We may thank previous management that note the ‘City’ was all too eager to dismiss for putting in place such traits and ensuring that the short term view that has been responsible for wrecking so much of Britain’s industrial base was never allowed to take hold in Rolls-Royce. Moreover, we must congratulate Sir John Rose and his team for doing nothing less than continuing to invest wherever it is appropriate, ensuring RR will remain ahead of its game for many years to come.
Howard Wheeldon is the Senior Strategist at BGC Partners
