"Real signs" of positive change in Civil Aerospace; still a bit early for us to turn Overweight
On June 2 we visited RR’s main Civil Aero (CA) facilities in Derby, UK. We came away with a much more positive impression than we did on our last visit (Sept 2013), when we wrote that “we were somewhat underwhelmed by the
sense of urgency [on cost reduction] in the CA division.” Clearly a lot has happened since then (5 group-level profit warnings, new group CEO, new group CFO, new head of CA). On this trip we met Mike Mosley, head of CA’s global operations, who was clear that RR is no longer in denial about the need for change, and that the process is underway. We remain Neutral rated on the shares given significant near-term headwinds across the group and a full valuation (on 2016-18E earnings). However, given RR’s current low earnings, any cost savings beat would have a fairly large impact on EPS estimates.
* “Real signs” of positive change: In mid-2011 then (new) CEO John
Rishton announced his intentions to cut RR’s costs and improve its cash
generation. So when we visited Derby in Sept 2013 we were very
disappointed to see little evidence of cultural change and a total lack of
posters and “visual management displays”. This may sound rather simplistic
but any investor who has visited a factory engaged in six-sigma / lean
manufacturing / kaizen etc. will be familiar with the “call to action”
motivation posted and, more importantly, the prominent visual displays
showing key metrics like scrap rates / overdue work / stock turns etc. The
good news is that Derby today has plenty of these posters (some examples
overleaf) and visual management displays (unsurprisingly we weren’t
allowed to take photos of these). We came away with the impression that
“Derby now gets it”, perhaps unsurprisingly after a slew of profit warnings.
* Better ‘line of sight’ over the business: Mr Mosley said the CA business
had robust data on the cost of products, but in the past a lot of this data was
in different silos. Today this data is being shared and RR feels that for the
first time it has ‘line of sight’ across the whole CA enterprise.
* Delayering of management: Recent management redundancies mean there
are now typically 7-8 layers between the CEO and shop floor, compared to
9-11 layers.
* More outsourcing, and more to low cost countries: For many years RR
has produced c30% of its engine parts and outsourced 70%. It is now
moving to 20%-80%. (We believe that RR could achieve this by the end of
this decade although it hasn’t given a formal target.) In addition, it is finding
new suppliers in low cost countries.
* “Pulse lines” for engine assembly: Volumes in the CA industry are
relatively low (c1,500 large aircraft pa) which means fully automated flow
production lines are not really suited to CA. However, RR is now
assembling engines on “pulse lines”, a hybrid solution where some work is
done in a stationary cell and then moved on the next station. On our last
visit, some RR engines were some being assembled on wooden pallets.