With lockdown memories receding into history, the outlook for the global aerospace industry is now broadly positive. Figures from the International Air Transport Association (IATA) point to a sustained recovery in total traffic (as measured in revenue passenger kilometres), while international flights, led by the Asia-Pacific region, were up by 85 per cent year on year in November. Volumes have yet to return to pre-pandemic levels, but all the key metrics are heading in the right direction. And despite ongoing supply chain disruption, sentiment is gradually improving across the sector – except, it would seem, for one conspicuous laggard close to home.
New Rolls-Royce chief delivers brutal assessment
Rolls-Royce (RR.) has had its struggles with defective turbine blades and a collapse in civil aviation traffic, but it was still slightly surprising that the new chief executive, Tufan Erginbilgic, chose a global staff broadcast to deliver a brutal assessment of the group’s prospects, describing the 116-year-old aerospace giant as a “burning platform”. The hyperbolic phrase has its origins in the Piper Alpha oil rig disaster and is essentially a call to arms designed to encourage (or perhaps shock) employees into adopting a radical change strategy, whatever that entails.
The Financial Times revealed that the group’s new boss used the address to launch a “transformation programme” – a somewhat sobering prospect for employees given that his predecessor had already canned around 9,000 jobs. He added that the group’s problems predate the pandemic and that its financial performance had persistently come up short of that of industry peers.
His apparent frustration will not be lost on shareholders, although it rather depends on which peers he is referencing. The group delivered an average return on capital of 5.6 per cent in the five years prior to the pandemic, together with an average free cash flow margin of 6.2 per cent, both of which are superior to those of General Electric (US:GE). By contrast, Raytheon Technologies (US:RTX), the parent company of Pratt & Whitney engines, trumped Rolls-Royce across a range of metrics, although that’s hardly surprising given that it's the world's leading manufacturer of guided missiles.
At any rate, it’s understandable why Erginbilgic has decided to lay down a marker early in his tenure, even though you could never accuse Warren East of ducking the hard decisions, especially given the unprecedented job cuts and the sale of ITP Aero. It’s just that any remedial benefits derived from previous restructurings are still obscured by the lingering impact of the global travel bans.
Long-haul passenger numbers and debt servicing
Last year, Rolls-Royce revised down its recovery timeframe for large engine flying hours; a concern given that a sizeable proportion of its revenue is based on how many hours its Trent jet engines are in service. It makes money by entering long-term service contracts for engines that it sells. That’s why long-haul passenger numbers are key to any improvement in finances. Unfortunately, the prolonged grounding of international air fleets was always going to weigh on the wider civil aviation industry long after passenger numbers recovered, not least because of the monumental debts accumulated during the downtime.
In September, Rolls-Royce completed its £2bn disposal programme and promptly settled an export-finance-backed loan due in 2025. That leaves roughly £4bn in outstanding debt, £500mn of which is due next year. It booked net operating cash flow of £597mn at the June half-year but saw an outflow from financing activities of £530mn, including £265mn in settlement of excess derivative contracts. The good news is that all drawn debt is on fixed interest rate terms and hedged into the low interest rate environment during 2019-20.
Hopes turn to UltraFan as environmental imperative mounts
However, it’s a capital-intensive industry and financial demands linked to R&D are seemingly boundless. Management is placing great store in the group’s UltraFan engine series; technology that could afford significant advantages in terms of both running costs and from an environmental perspective. The engine has been designed to run on sustainable aviation fuel and is about 20 per cent more efficient than existing engines. Industry rivals such as GE Aerospace are busy developing alternative technologies, such as the CFM RISE Engine, but both GE and Raytheon have cautioned that lingering supply chain issues and labour shortages could slow the rate of recovery. Testing of an UltraFan prototype is being undertaken in the early part of this year and, if successful, it could also be modified for use in narrow-body, short-haul aircraft, a highly advantageous scenario.
Technology aside, it’s certainly possible that Erginbilgic was merely trying to galvanise his troops, albeit with a stick rather than a carrot. He has a track record of rationalising businesses, so further job losses cannot be ruled out, nor a divisional spin-off for that matter. However, it’s worth noting that the chief executive’s assessment, withering as it was, stands in contrast to a strong technical signal on share price support at the end of 2022.
