Investors in Rolls-Royce, who in recent years have had little reason to celebrate, are in a cheery mood at the start of the new year.
Rising 224 per cent in 2023 to 299.7p, the FTSE 100 engineer’s shares have recorded their best annual performance since the company was privatised in 1987, heading the list of top gainers in the Stoxx 600 of Europe’s largest listed companies in 2023.
The sharp shift in the company’s fortunes on the stock market has coincided with the arrival of chief executive Tufan Erginbilgic, the oil industry veteran who took the controls at Rolls-Royce in January 2023 with a mandate to improve performance and drive down costs.
He has been brutally — and publicly — frank on Rolls-Royce’s shortcomings, shaking up senior management, announcing job cuts and setting ambitious financial targets.
Many investors and analysts have bought into the turnaround story, including longtime bear David Perry of JPMorgan, who in December issued an “overweight” rating on the stock for the first time since October 2014.
“I have never seen a CEO have such a positive impact in such a short period of time,” said Perry.
“Recovering market conditions have helped, but much of this recovery was expected 12 months ago. So we think most of the improvement in Rolls-Royce’s 2023 performance and its . . . upgraded financial targets is down to initiatives implemented by Erginbilgic and his team,” he added.
Despite the enthusiasm among many towards the new CEO, others are keen to stress that while he can take credit for bringing in greater cost discipline, he has been fortunate with timing — notably the dramatic rebound in global travel as well as the rise in defence spending by governments.
The company makes most of its money from long-term service agreements on its passenger jet engines, and the recovery in international air travel, notably in the Asia-Pacific region, has brought more cash flowing in.
“He has a following wind from increased flying, strong defence [spending] and the strong US dollar; and little in the way of new product spend,” said one former industry executive. It would be hard to tell what impact his actions were already having, they added.
Rolls-Royce is no newcomer to restructurings. The 117-year-old company’s recent history is marked by successive turnaround plans launched by different chief executives.
The group is best known for building and maintaining large engines for passenger jets but it also makes turbines for fighter aeroplanes and reactors that power nuclear submarines. It also produces diesel and gas engines for ships and power generation.
Despite its longstanding position as Britain’s pre-eminent engineer, Rolls-Royce’s operating margins have historically underperformed those of larger peers such as America’s General Electric. More recently, its pursuit of trying to win market share from rival engine makers saw it sometimes sacrifice profitability and price.
It was also particularly badly hit by the pandemic due to its focus on building engines for widebody aircraft that fly long-haul, a segment of the market that suffered from the decline in international flying.
When Erginbilgic took over from his predecessor Warren East, he joined with a reputation as a formidable operator. Key priorities were to reduce the losses when the company makes and sells an engine, as well as to ensure that costs taken out during the restructuring did not creep back in once volumes returned as the industry recovered.
He has acted quickly to put his stamp on the organisation; almost half of Rolls-Royce’s senior executives, including former chief financial officer Panos Kakoullis, have changed positions or left as part of the restructuring and his move to centralise core functions such as human resources and purchasing.
Erginbilgic has been eager to stress a company-led turnaround rather than on that depends on the market.
“It is our actions that are driving the performance. It is not the environment,” he said at the company’s capital markets day in November where he announced new midterm targets for operating profits of up to £2.8bn by about 2027, four times the amount it reported in 2022.
The targets, “actually mean a step change in performance”, Erginbilgic said, noting the company had already upgraded its 2023 guidance at the time of its half-year results in August.
“Those numbers in terms of cash and operating profit will be our best on record, while engine flying hours are still at around 86 per cent,” he said.
The group is aiming to increase operating margins to 13-15 per cent as part of the midterm plan. In its core civil aerospace business, it expects to achieve operating margins of 15-17 per cent, up from 2.5 per cent in 2022, a move that would bring it closer to rivals such as GE.
Nick Cunningham, analyst at Agency Partners, said the “underlying volume increase in engine flight hours and the underlying revenue increase from long-term service agreements is not a surprise”, noting that “China reopened at the beginning of [2023]”.
He nevertheless credits Erginbilgic with laying the foundations for better future performance. “A lot of what he is doing in terms of trying to improve the contract structure and the financial discipline — managing working capital, not writing new, bad contracts — those things pay off over time,” said Cunningham.
Graeme Forster, portfolio manager at Orbis, which bought into Rolls-Royce shares about seven years ago, argues that some credit is also due to Rolls-Royce’s “no-nonsense” chair, Anita Frew. Frew, who appointed Erginbilgic, has also overhauled the board since she herself started in October 2021.
Warren East, Erginbilgic’s predecessor, who ensured the company survived Covid and launched his own restructuring programme, including 9,000 job losses to save £1.3bn in costs, also deserves credit, according to Forster.
Company insiders say that in the short term at least, the outlook is good. With the latest commitment by Turkish Airlines to purchase more than 200 Airbus aircraft, including A350s which are powered by Rolls-Royce engines, 2023 will be the best year for Rolls-Royce in terms of new orders for 15 years.
A key mark of success will be when Rolls-Royce is upgraded to investment grade by all of the rating agencies. S&P Global upgraded it to BB+ in December. Some analysts believe a further shift higher could happen relatively soon, which could pave the way for the company to start paying a dividend again.
The engineer’s balance sheet will also benefit from not having to spend heavily on a new engine development in the medium-term. But one big strategic question still looms over Rolls-Royce: how does it re-enter the lucrative market for the engines powering narrow-body commercial airliners.
The company left that segment more than a decade ago when it pulled out of a joint venture with Pratt & Whitney of the US.
Erginbilgic has made much of the fact that the company could use new engine technologies from its UltraFan programme to work with another supplier. The next generation UltraFan demonstrator engine aims to be 25 per cent more efficient than the group’s first Trent engines.
Whether he stays the course for this to happen — Erginbilgic is 64 years old — or whether it will be a challenge for a successor, remains to be seen.
For now, the focus will be on ensuring Rolls-Royce delivers on those new targets, including improving the earnings margins on its long-term service agreements with airline customers.
To get there, the company will not only need to charge higher prices and reduce its own costs, but also improve the durability or “time on wing” of its aircraft engines so they fly for longer before coming in for maintenance.
Rolls-Royce’s R&D engineers are now “focused on improving time on wing”, said JPMorgan’s Perry. “They will need to deliver the promised improvements . . . if Rolls-Royce is to achieve its targets.”
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