Eject from Rolls-Royce

A market shift from large jumbo jets to more nimble aircraft has also affected Rolls-Royce’s business, and specifically its order pipeline. It incurred a £186m exceptional charge connected with the Trent 900, after Airbus decided to shorten its A380 programme. Airbus’s decision meant a reduction to an order agreed under a $9.2bn (£7.2bn) deal in 2015 to provide engines and aftercare for 50 Emirates A380s (revised up to 52 in 2016). Rolls-Royce had already delivered engines for 19 aircraft, and would supply 56 engines for 14 remaining aircraft instead. The Trent 900s have also not been without fault – low durability of various parts cost Rolls-Royce £51m and £14m in cash costs over 2017 and 2018 respectively.

The raft of exceptional charges in 2018 meant Rolls' underlying £616m pre-tax profit sank to a statutory loss of £803m. We feel there are in fact grounds to consider design problems an "underlying" issue in themselves. The statutory numbers could have been worse had Rolls not changed its accounting policies in 2016 to start capitalising more research and development (R&D) cost. R&D capitalisation rose from £99m to £342m from 2016 to 2017. Meanwhile, in 2018, the £768m of R&D that was expensed and amortised in the profit-and-loss account compared with £1.1bn of spending.

Fans of Rolls can, however, point to improved free cash flow (FCF) last year. FCF rose from £259m in 2017 to £568m in 2018. However, there are reasons to feel lukewarm about this number, too. For one thing, standardisation of payment terms led to a cash boost of £400m during the year, which is not expected to be repeated. What's more, changes to revenue recognition rules have reveal how dependent Rolls' cash flows are on advanced payments by customers for future aftersales service work. Indeed, during 2018 FCF was boosted by £944m of long-term service agreement (LSTA) payments. Broker JP Morgan estimates that when this work is undertaken, only 35 per cent of the receipts will represent profit and therefore be available to shareholders.

The company's finances are also arguably less strong than they appear in our table. While Rolls did report a hearty net cash position at the end of 2018, boosted by £573m proceeds from the disposal of its L'Orange fuel injection business, this does not reflect its heavy reliance on operating leases, which will need to be brought onto the balance sheet this year. Using a standard method of valuing lease liabilities at seven times annual rents (£300m in 2018) gives a value for the group's lease obligations of £2.1bn. The chart below shows the advance in lease obligations as reported in the annual accounts.