New CEO’s maiden ID: flight check
Why we write this report
The share has been the sector’s worst performer over 12-months. The arrivals of Warren East as
CEO and of an activist fund in the share capital have revived hopes of turnaround. Communication
and transparency have started to improve, attracting interest from value investors tempted to capture
the potential of a large, young installed base that should turn cash generative over time. In this report,
we discuss six key issues that the CEO may address at the Investor Day on 24 November.
Trent unit costs are crucial for mitigating expected price pressure
We believe the economics of aircraft engine programs are changing, with the added visibility from
the rising proportion of monopoly positions (80% of Trent engine deliveries by 2020e) offset by
stronger cash pressure in ramp up. We expect three years of heavy pricing pressure on Trent
deliveries. The CEO’s main lever is probably on costs by accelerating facility specialisation.
Don’t minimize regulatory risk
We see a case for the EU to start a formal investigation of engine-makers’ aftermarket practices,
including Rolls-Royce’s TCA model on monopoly propulsion positions. Less protection of
aftermarket revenues on engines like the Trent700 and TrentXWB could prevent the return of value
investors to the share. SFO risk also needs watching closely (Petrobras case).
Structural risks from R&D and at defence; cyclical risks weigh on short-term outlook
We see short-term downside risk to cyclical activities (up to 46% of sales), on which Rolls is likely
to comment in its IMS, due on 12 November. We also explain why R&D (outside large engines)
and defence (at peak margin) could increasingly become headwinds to the group’s earnings.
Long-cycle businesses take time to fix – we maintain our Neutral rating
The uncertainties on the economics of new engine programs complicate the valuation exercise.
Most of the issues, including regulatory, are unlikely to be resolved in the short run, hence our
Neutral stance. Turning more optimistic depends notably on positive outcomes to the debate on the
pricing/unit cost equation, which would back the thesis of a recovery in cash generation.