Rolls-Royce’s shares are riding high on the back of a booming civil market and strong defence sales despite concerns over the recent dearth of Airbus A340-500/600 sales, the UK manufacturer’s ongoing exclusion from the Boeing 737 engine market and the imminent cancellation of the F136 Joint Strike Fighter alternative engine.
Preliminary full year results for 2005, published last week, justify the bullish sentiment that has boosted R-R’s share price by nearly 70% over the past year to close at around 446 pence (785¢) on 8 February. It posted sales of £3.51 billion in its civil aerospace division compared with £3.04 billion in 2004. Underlying profit before financing costs was £454 million, £260 million higher than the previous year.
The potential for sales of 4,000 A350s and 787s over the next 20 years, according to one analyst, is a key reason for R-R’s bullishness. Today’s situation is in stark contrast to the three-way battle between engine manufacturers in the 1990s when “nobody made any money”, he says, adding “people are beginning to believe the long-term story. Inclusion on new aircraft programmes in a duopoly shows R-R’s success can continue.”
R-R itself attributes its recent success to its long-term investment strategy: “Our long-term business model is beginning to show dividends,” it says. Analysts agree: “Rolls-Royce is a better company than it’s ever been. The market has finally caught on to this,” says Sandy Morris of ABN Amro. He adds that, over recent years as R-R sacrificed short-term profitability to its long-term investment strategy, it lost investor confidence. “The market took its eye off the ball during Rolls-Royce’s extended period of investment,” he adds.
R-R has also tripled its share of the civil engine market over the past 20 years to its current level of around 30%. One key to R-R’s success is that it has changed its approach to aftermarket services. Long-term service contracts add to investor confidence because of increased visibility. The company delivered 881 civil aircraft engines in 2005, 7% more than the previous year. But out of £3.5 billion total revenues for the civil sector, 59% – or £2 billion – was generated by services. Some observers have questioned how R-R can maintain a lucrative aftermarket sector as engines become more and more reliable. But with an engine providing around one and half times its value in aftermarket revenue over a lifetime, this could add up to as much as $72 billion for the A350 and 787 combined over 50 years, an analyst says.
But it is not all good news, with the group’s three-year moving average share of civil engine orders falling to 23% from 30%, largely as a result of the high number of 737 sales in 2005, for which the group does not offer an engine, highlighting a gap in its portfolio.
Analysts are confident R-R will offer an engine for the eventual 737 replacement, but until then, this area of the market is off limits. Despite a continuing fall in regional aircraft engine deliveries, R-R predicts an overall increase in the number of civil engines delivered in 2006, as the Trent 900 enters service on the ultra-large A380.
The so-called “giveaway” deals on other aircraft programmes that helped R-R gain more and more of a share in the market have been justified by its subsequent aftermarket success. The writedowns the company has had to make for losses on engine sales total no more than 1-2% of yearly revenues, an analyst points out, or less than £400 million over the last 15 years on sales of as much as £10 billion.
There are also clouds on the horizon as the A340-500/600 – which is exclusively R-R powered – faces a strong threat from the GE-powered 777-300ER/200LR family.
But delays to the A380’s entry into service are unlikely to seriously dent R-R’s performance: in this instance the fact that R-R relies on aftermarket services, not new engine sales, for its profit works in the company’s favour. And over the lifetime of an engine, the possible year of lost service revenues will amount to no more than “a drop in the ocean”, one analyst believes. Perhaps the biggest obstacle facing R-R in terms of the A380 is that the overall market for the aircraft is relatively small, with Airbus failing to expand the orderbook as rapidly as some had hoped.
On the military side, the group made £180 million profit on sales of £1.41 billion, 3% higher year-on-year. One analyst predicts the trend towards increased outsourcing could bring benefits as defence budgets come under pressure, with R-R’s US business standing to gain. But the probable cancellation of R-R and GE’s alternative engine for the Joint Strike Fighter is bad news. Analyst Ben Fidler of Deutsche Bank says “the initial development programme for the engine was worth $2.4 billion, with about $1 billion due to R-R. The cancellation is negative for R-R longer term.”
HELEN MASSY-BERESFORD / LONDON
Source: Flight International
