Ominous silence in the engine room

Civil aerospace represents more than half of Rolls-Royce's business and since the terrorist attacks in America, the company's stock market value has almost halved. Yet the management seems reluctant to reveal its strategy for dealing with the crisis.
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The Independent Online

Like nature, the stock market abhors a vacuum. Investors fear the worst when a company is circumspect about current trading or future prospects.

So it is with Rolls-Royce. The aero-engine giant has been something of an information-free zone since two Boeing jets ploughed into the World Trade Centre's twin towers on 11 September and plunged the civil aerospace industry into renewed crisis. Almost immediately, air travel nosedived and the global airline industry was hit with a slew of bankruptcy warnings – and in the case of Swissair, collapse.

But it was another eight days before Rolls-Royce finally issued the blandest of statements to the Stock Exchange, in which its chief executive John Rose merely said it was too early to evaluate the effect of the disaster. "We are working closely with our customers as they reassess the outlook for their businesses," he declared. "We will continue to actively manage the business in response to the changing priorities of the market. We will keep shareholders informed as the short-term outlook for the industry becomes clearer."

Requests for further clarification are declined. In fact, Rolls-Royce refuses to discuss the subject at all on the record and another statement is not expected for several weeks.

This wall of silence is unusual for a company that often claims it is misunderstood. After all, most people still think Rolls-Royce makes luxury cars. (It retains ultimate control over the rights to the Rolls-Royce name, but the Rollers are now being built by Volkswagen and in 2003 German rival BMW will take over).

The lack of news from Rolls-Royce is all the more worrying because civil aerospace represents 54 per cent of its sales. The balance is in the defence, marine and energy sectors. Into this information void have stepped aggressive sellers of the shares. Since the terrorist attacks in America, Rolls-Royce's stock market value has almost halved, dragging the share price down to eight-year lows.

While Rolls-Royce and Mr Rose remain tight-lipped, its two main US rivals have been far more forthcoming. General Electric was quickest off the mark with a profits warning, closely followed by Pratt & Whitney, which said its profits would fall by $250m (£170m) in the fourth quarter of this year. But the real impact of the crisis on the aero-engine makers is likely to be felt later, as airlines slash capacity to counter falling passenger demand.

"They know it's going to be bad, but it is unclear how bad it is going to be because of the long lead times," says Colin Crook, aerospace analyst at Lehman Brothers.

Planes scheduled for delivery over the next few months won't be greatly affected, since airlines would have to pay stiff penalties for last-minute cancellations. But those deliveries will only add to a glut of planes in the depressed industry, making it even more likely future deliveries will slow sharply.

Among the major aircraft manufacturers supplied by Rolls-Royce, Boeing says its delivery total for this year, which was expected to be 538, could drop to 500. Deliveries in 2002 could be in the low 400s against previous estimates of up to 520. As well as hacking production estimates, Boeing is also shedding up to 30,000 jobs, or almost a third of its workforce.

EADS, the company that owns 80 per cent of the European aircraft-making consortium Airbus Industrie, is more sanguine. Deliveries this year will fall from an estimated 336 to about 320, and production will be frozen at that level next year, even though it has 375 orders on its books. And there are as yet no plans to lay off any of its 44,000 staff.

The big unknown, though, for both Boeing and Airbus – and, therefore, Rolls-Royce – is what happens in 2003. Some analysts think the total number of aircraft deliveries could be less than 500. That's half the level estimated before the suicide hijackings and worse than the fall-off seen after the outbreak of the Gulf War in 1990-91.

For Rolls-Royce, the fall in new engine orders is bad enough. But an even more immediate challenge is the loss of lucrative spares and overhaul contracts as airlines axe schedules and park unwanted planes in the Arizona desert. The company makes much of its money selling engines at little profit in return for high-margin after-market work that lasts for the 25-year lifespan of a typical jet.

Before the attacks on America, Rolls-Royce could reasonably claim to be relatively immune to any downturn in the civil aerospace market. In part that was due to a broad spread of businesses across the defence, marine and energy sectors. But it was also because of the perceived strength of its after-market business. Planes most likely to be retired first in any slowdown are older ones such as the early 727 and 737 Boeing jets powered by Pratt & Whitney engines. Indeed, the average age of Rolls-Royce engines is eight years compared to 18 years for Pratt & Whitney.

But the speed and scale of the downturn since 11 September have forced analysts to think again. "In our view, Rolls is vulnerable both to falls in new engine volumes and also to reduced after-market revenues as a result of falling aircraft utilisation and accelerating aircraft retirals and groundings," Sash Tusa of investment bank Goldman Sachs told clients this week. Aircraft with Rolls-Royce engines that could be put out to grass include the Fokker 100 and some Boeing 757s, he added.

All this means that analysts have been taking a scythe to their profits forecasts. Lehman Brothers, for example, has slashed its pre-exceptional and goodwill estimate by almost two-thirds to £218m for 2003, against £275m next year.

The downward revisions are all the more galling for Mr Rose because 2003 was meant to be the year of delivery, when the company's many critics in the City would be proved wrong. Ever since privatisation in 1987, Rolls-Royce has become a byword for "jam tomorrow". Even before 11 September, its shares had underperformed the FTSE-100 index by almost 50 per cent since it was sold off by the Thatcher government.

Last year, Rolls-Royce was briefly dumped from the blue-chip index for only the second time since privatisation, after abandoning its four-year-old promise of double-digit earnings growth. Ejection came despite news that the company had beaten the combined might of its US rivals, GE and Pratt & Whitney, to land the first engine orders for the Airbus A380 superjumbo. But hard-noses in the City are unimpressed by news of new orders alone; investors would rather wait to see evidence of the terms on which they were won.

With Rolls-Royce there is the added pressure from some analysts to streamline its range of aircraft engines and focus on more profitable parts of the business. Rolls-Royce engines now power 32 different types of aircraft, compared with just four a decade ago.

Such a strategic shift may become a necessity after 11 September. Rolls-Royce was already planning to cut its workforce from 43,000 to about 38,000 over the next two years as it continued to outsource more work. But analysts believe that more radical cost-cutting is now required.

"Rolls remains highly vertically integrated, with major manufacturing sites supplying OE (original equipment), after-market, and defence and energy," says Goldman Sachs' Sash Tusa. "Rolls has historically reacted to similar market downturns with major restructuring." He sees an extra £50m restructuring charge in the second half, on top of the existing £50m rationalisation programme.

Debt is also an issue. Rolls-Royce used to boast a rock-solid balance sheet. The company even managed to get its last rights issue away in 1993 when it had cash in the bank. But the £576m acquisition of Vickers two years ago changed all that.

"Rolls-Royce is as heavily indebted as it has been," notes Lehman's Mr Crook. Net borrowings of £940m are high compared with a stock market valuation of just £1.9bn, though servicing that level of debt is unlikely to jeopardise the dividend, brokers say.

In an ideal world, Rolls-Royce would sell unwanted businesses to ease the strain on the balance sheet. It still has a tanks division that came with the Vickers deal. In the current climate, with all the talk of war on terrorism, that might seem an asset. In fact, the armoured vehicle industry suffers from massive overcapacity, so Rolls looks like it is stuck with tanks for the time being.

There is one encouraging sign, however. Last week directors opened their wallets and bought Rolls-Royce shares at what they must believe are bargain basement prices. Mr Rose himself splashed out almost £50,000 on company stock. But so far the move has done little to stabilise the share price. Indeed, Mr Rose and his fellow directors are already out of pocket after the shares went into another tail-spin this week on news that Goldman Sachs had set a price target of just 100p.

For the time being, at least, it seems actions alone at Rolls-Royce do not speak as loud as those absent words.

FACT FILE

Market capitalisation: £1.91bn

Sales: £5.9bn in 2000 (£4.7bn)

Pre-tax profits: £166m (£360m)

Main business: Second-largest aircraft engine maker in the world, behind General Electric. Purchase of Vickers made Rolls-Royce one of the world's largest makers of marine propulsion systems. Also builds power generation systems

Key executives: Sir Ralph Robins, chairman; John Rose, chief executive; Paul Heiden, finance director

Employees: 43,000

A FAR CRY FROM THE EARLY DAYS OF MR ROLLS AND MR ROYCE

1884: Electrical and mechanical business established by Henry Royce

1904: Royce builds his first motor car (pictured). Meets Charles Rolls at Midland Hotel, Manchester. They agree that Royce will make a range of cars to be sold exclusively by Rolls's company, bearing the name Rolls-Royce

1906: Rolls-Royce company formed; six-cylinder Silver Ghost is launched within a year

1914: Royce designs his first aero engine, the Eagle, providing some half of the total horsepower used by allied aircraft in the First World War

1933: Royce dies. Work on Merlin engine under way

1940: Merlin powers Hurricanes and Spitfires in the Battle of Britain

1944: Development begins of the aero-gas turbine, pioneered by Sir Frank Whittle

1953: Rolls-Royce enters civil aviation market with the Dart engine in the Vickers Viscount

1965: Merger with aero-engine maker Bristol Siddeley

1971: Problems with RB211 engine for Lockheed's TriStar jet send Rolls-Royce into receivership. Aero-engine business taken into state ownership and Rolls-Royce Motors Ltd formed as a separate company

1980: Vickers buys Rolls-Royce Motors

1987: Privatisation of Rolls-Royce under the Conservative government

1990: Aero-engines joint venture formed with BMW. (Rolls-Royce took full control in January 2000)

1996: Rolls-Royce Motors sold by Vickers to Volkswagen.

1998: BMW acquires rights to name and marque for use on Rolls-Royce cars from Rolls-Royce for £40m. (BMW will take over responsibility for building the cars from the beginning of 2003)

1999: Rolls-Royce pays £576m for Vickers

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