Rolls Royce Holdings Plc Good half year progress

Rolls Royce Holdings Plc(LON:RR.), today announced half year results 2018.

Commenting on the results, Rolls Royce, Warren East, Chief Executive: “We continued to make good progress in the first half. Financial results were ahead of our expectations with strong growth from Civil Aerospace and Power Systems and we achieved a number of operational and technological milestones. Reflecting our progress to date and growing confidence for the full year, we now expect both underlying profit and cash flow for 2018 to be in the upper half of our guidance range. We continue to be impacted by the challenge of managing significant Trent 1000 in-service issues and have recognised an exceptional charge of £554m, representing the profit impact of that part of the total current and estimated costs out to 2022 that is considered to be abnormal in nature.”

Group financial highlights

· Underlying revenue of £7,040m up 14%; reported revenue of £7,487m up 12%. Civil Aerospace revenues up 26%, Power Systems up 13% and Defence remains flat

· Underlying operating profit up £205m to £141m; strong growth in Civil Aerospace and Power Systems; reported operating loss of £775m

· Group free cash flow improvement of £211m on prior year outflow of £339m driven by good cash flows in Defence and reduced outflow in Civil Aerospace

· Exceptional charge in the income statement for Trent 1000 in-service issues of £554m representing that part of the total estimated cost for the period to 2022 that is considered to be abnormal in nature

· Estimate of FY 2018 cash costs for Trent 1000 and Trent 900 in-service issues approximately £450m, in line with 15 June 2018 guidance, FY 2019 combined cash cost now expected to be at a similar level to 2018, before declining by at least £100m in 2020; despite this we expect to deliver improved 2019 underlying free cash flow compared to our guidance for 2018

· Since the year end net funds have improved by £470m primarily driven by proceeds from the disposal of L’Orange (€673m) completed on 1 June 2018; Commercial Marine sale (expected net proceeds £350m-£400m) announced on 6 July 2018

· FY 2018 underlying profit and free cash flows; now expected to be in the upper half of our guidance range

Group operational highlights

· Positive early progress on the restructuring plan. Target run-rate savings of £400m p.a. by end of 2020

· Civil Aerospace widebody service revenues up 22% on an underlying basis; large engine production ramp-up continues; widebody deliveries up 24%; 259 engines sold in H1 2018; Trent 7000 certification; launch of Pearl engine for business jets, successful testing of Advance3

· Continued strong growth at Power Systems; OE and Service growth across almost all end markets

2018 Half Year Results: Business units

2018 Outlook: Increasing confidence

At our 2017 Full Year Results in March, we provided a 2018 full year outlook for the Group excluding ITP Aero and under our prior reporting structure. Our guidance has been updated to reflect our revised reporting structure. We are now providing guidance on the basis of our core business (which includes ITP Aero and excludes non-core operations either already sold or held for sale). For our core business, we expect 2018 underlying operating profit of around £450m +/- £100m and underlying free cash flow of around £400m +/- £100m.

Commenting on the Group’s outlook, Warren East, added: “Rolls-Royce is at a pivotal moment in its history. After a long period of significant investment and innovation, we are poised to become the world-leader in large aircraft engines. Now we need to deliver the fundamental changes that will enable us to realise the potential of our position, delivering improved returns while continuing to invest in the innovation needed to realise our long-term aspiration to be the world’s leading industrial technology company. Our new business structure and drive for greater pace and simplicity, combined with our growing installed base, means we are well placed to exceed free cash flow of £1bn by 2020 and push towards our mid-term ambition for free cash flow per share to exceed £1.

This is the time for execution. In Civil Aerospace our installed widebody fleet will continue to grow and we will strive to further reduce cash deficits on engine sales, whilst working hard to minimise the disruption caused to our customers by in-service issues. The benefits of creating a single Defence operation with greater scale and the ability to offer customers a broader range of products and services, should present us with new opportunities. In Power Systems the continued expansion of our end markets is driving strong volume and this, combined with the further product portfolio rationalisation and the development of new service offerings, gives us confidence for the full year.”

Restructuring update

Since our initial announcement on 17 January 2018, we have made progress with our plans to simplify the Group into three customer-focused business units. Our new Defence business has been formed by combining both our Naval and Submarine businesses with Defence Aerospace; Civil Nuclear has been moved into Power Systems; we successfully completed the sale of L’Orange and we announced an agreement to sell Commercial Marine.

While we are determined to establish a strong foundation for the future of Rolls-Royce, we are also acutely aware that this restructuring will impact 4,600 colleagues. Restructuring efforts are now focused on removing duplication and fixing the inefficient processes and interfaces across our business. All parts of the business will be managed under a radically simplified structure, alongside an operating framework that clearly outlines roles and responsibilities.

Communication with our people is key and since the restructuring announcement on 14 June 2018, the Executive Leadership Team has held many face-to-face discussions with thousands of employees across the Group, collecting feedback, helping us to set priorities and identifying challenges ahead. This is a tremendous opportunity to create the world’s leading industrial technology company.

Trent 1000 in-service issues and costs

The Trent 1000 in-service engine issues have caused significant disruption for a number of our customers, which we sincerely regret. We continue to work hard to remedy this situation and have made further good progress on the implementation of long-term solutions in the first half of the year. We have significantly increased our Trent 1000 maintenance and overhaul capacity, sought ways to reduce engine shop visit turnaround times and have added approximately 50% more turbine blade capacity since the start of the year. We recently confirmed that we have now started certification testing of a redesigned intermediate compressor rotor blade for Trent 1000 Package C engines, with a redesign for Trent 1000 Package B engines to follow. In addition, as a precautionary measure, we have launched and, are in the process of testing, a redesign of the blade common to the Trent 1000 TEN and Trent 7000 engines. We continue to make good progress in addressing the other known issues affecting Trent 1000 engines.

Having provided updated guidance on the cost of these actions in 2018 at our Capital Markets Event in June we are now clarifying the incremental cost of this dynamic situation on 2019 and beyond. Our current assessment is that the combined cash cost of both the Trent 1000 and Trent 900 in-service issues will be at a similar level in 2019 to the approximately £450m we expect in 2018, before declining by at least £100m in 2020. We still expect to deliver an improvement in 2019 underlying core free cash flow compared to our guidance for 2018, marking a further step towards our 2020 free cash flow ambition. The cash costs of the Trent 1000 and Trent 900 issues are expected to step down materially after 2020, with all technical changes expected to be fully embodied into the Trent 1000 and Trent 900 fleets by 2022.

In H1 2018, following the Airworthiness Directives mandating additional inspections, an exceptional charge of £554m has been taken to the income statement. It reflects the impact of the abnormal costs we are incurring to resolve the Trent 1000 in-service issues, which fall outside the scope of our normal TotalCare costs. The charge represents around 40% of the total cash costs expected to be incurred in resolving the Trent 1000 issues for the period to 2022 and is not incremental to them. The remainder of these costs will be recognised over time through our normal contract accounting margins. Cash costs on the Trent 1000 in-service issues will continue to be fully reflected in free cash flow.

Free cash flow improvement of £211m versus prior year

Overall Group free cash flow improved materially in H1, with an outflow of £72m (2017: £(339m)). Our core business generated a free cash inflow of £10m (2017 H1: £(264)m). The good year-on-year cash flow improvement was driven by increased cash flows in the Civil Aerospace aftermarket from strong growth in engine flying hours and T&M aftermarket activity, better deposit inflows at Defence and a more balanced profile of Civil spare engine deliveries in H1 vs H2 than in the prior year. These more than offset the increased level of R&D cash spend and higher cash costs incurred on Trent 1000 and Trent 900 in-service issues.

L’Orange disposal and announcement of sale of Commercial Marine

The disposal of L’Orange to Woodward Inc. for €673m proceeds completed on 1 June 2018. We also announced the sale of Commercial Marine to KONGSBERG on 6 July 2018 for a total value of £500m, with expected net proceeds of around £350m to £400m dependent upon the final outturn working capital at completion. The proceeds from these disposals will be used to strengthen our balance sheet and provide additional capital to judiciously pursue opportunities that will drive greater returns for the Group. Both L’Orange and Commercial Marine have been reported as non-core businesses in our 2018 Half Year Results.

Balance sheet, capital allocation and payments to shareholders

As we outlined at our Capital Markets Event, a disciplined approach to capital allocation and to sustaining a healthy balance sheet will play a major part in driving our long-term growth. Focusing on improving our return on capital is key and implementing a new KPI, Cash Return on Invested Capital (CROIC), will help us drive this across the Group. Through improved free cash flow generation, we aim to maintain a strong investment grade rating and ultimately return to A-grade status. In the first half net funds have improved by £470m to a net cash position of £165m. The interim payment to shareholders is held at 4.6 pence (H1 2017: 4.6 pence). Restoring our shareholder payments to an appropriate level over time as free cash flow grows will be a key capital allocation priority.

Financial highlights – core business data table (unless otherwise stated)

Key drivers of increased returns:

· Civil Aerospace OE cash deficit per engine reduced by 15% from 2017 full year average

· Reduction in C&A cost in Civil Aerospace and Defence; Power Systems C&A costs increased as pay escalation not yet offset by headcount changes, together with phasing differences compared to 2017

· Cash R&D costs increased as planned due to launch of new engines. Mid-term R&D still expected to fall in-line with our mid-term ambition

· Progress on restructuring with consultations underway. Retain confidence in target run-rate savings of £400m p.a. by end of 2020

2018 Business Unit highlights

The commentary in this section relates to the core business and is provided on an underlying basis with year-on-year changes at constant currency3.

Civil Aerospace – underlying revenue £3,600m, growing 26%, underlying operating loss £(112m)

· Underlying revenue growth of 26% driven by a 24% increase in sales volumes of installed engines and spare engines, including to joint ventures, and increased services activity

· Underlying operating loss reduced by £149m to £(112)m reflecting strong aftermarket trading including increased spare parts sales, higher OE spare engine volumes and increased net R&D capitalisation of £174m, offsetting £(154)m of contract accounting adjustments

· Continued expansion of the in-service fleet; widebody underlying engine flying hours +20%; increase in major LTSA shop visits as expected as a number of Trent 700 engine have had first overhauls

· Continuing progress on installed OE unit deficit reduction – fell by 15% in the first half; cost reduction and pricing improvements on Trent XWB-84, where we continue to work towards break even by 2020

· Milestone achievements in new engine programmes; launched first of a new family of engines for business aviation with the Pearl 15; Trent XWB-97 entered into service on the Airbus A350-1000; Trent 7000 achieved EASA certification

Defence – underlying revenue £1,415m, remaining flat, underlying operating profit £162m

· Underlying revenue flat with modest increase in OE offset by largely stable services revenues

· Underlying operating profit down £6m due to higher R&D spend reflecting ongoing future programme development partly offset by reduced C&A

· Progress combining our enlarged Defence business; providing integrated customer solutions

· The MT30 has maintained its position as a core naval engine of choice with Japan the fifth nation to select the engine for a major naval programme

· Partner in Team Tempest, a collaboration to develop the UK’s future Combat Air Strategy

· Orders weighted to second half with a strong pipeline in Combat, Naval and Submarines

Power Systems – underlying revenue £1,471m, growing +13%, underlying operating profit £80m

· Core underlying revenue increased by 13% driven by growth in both OE 14% and services 12%; following good growth in almost all applications from both market strength and management actions on sales

· Core underlying operating profit saw a material improvement on the prior year driven primarily by higher volumes; 180bps rise in underlying gross margin to 24.1%

· Growth in digitalisation increasing fleet connectivity; recent launch of pilot Factory of the Future and Service of the Future to better align internal processes and customer demands

· Recent launch of pioneering Series 4000 marine gas engine demonstrates capability in meeting stringent emissions regulation

· Full year order coverage currently over 80% versus circa 70% in prior year

· Meaningful progress made on MTU Yuchai Power joint venture as part of wider growth strategy in China

ITP Aero – underlying revenue £375m, growth of 19%, underlying operating profit £40m

· Strong revenue progress in H1 to £375m driven by higher Civil Aerospace OE and aftermarket revenues primarily on Rolls-Royce related programmes

· Significantly improved underlying operating profit in H1, increasing £32m to £40m reflecting the higher Civil Aerospace revenues and better product mix in the period

· Confidence in the full year outlook