How Chinese Slowdown Turned Rolls-Royce's Slump Into a Crisis

Inside The China International Aviation & Aerospace Exhibition

Attendees stand near a Rolls-Royce Holdings Plc Trent XWB aircraft engine during the China International Aviation and Aerospace Exhibition in Zhuhai, Guangdong province, China, on Nov. 12, 2014.

Photographer: Brent Lewin/Bloomberg
  • Asian economy is key factor in mystery wide-body slide
  • Glut of new jets idling older models even with cheap oil

Rolls-Royce Holdings Plc’s revelation last week that a 350 million-pound ($533 million) earnings hit expected next year is in large part due to lower deployment of older wide-body planes surprised investors who had believed cheap oil would make such aircraft more popular.

The reality, Chief Executive Officer Warren East said in an interview, is that models such as Airbus Group SE’s out-of-production A340 and older Boeing Co. 777s remain out of favor even with cheap fuel, as airlines add vast numbers of new jets in an Asian market feeling the strain of China’s economic slowdown.

That’s weighing on maintenance revenue at London-based Rolls, which gets the bulk of income from overhaul work calculated according to hours flown.

“China has definitely affected the Asian economy in a serious way,” said East, who blamed 150 million pounds of the revision on wide-body woes. “Economies are depressed, fewer people are traveling and less cargo is traveling. You’ve seen some of the Asian airlines parking up planes because of that.”

The idling of Rolls-powered twin-aisle jets in the region is surging, according to Bloomberg Intelligence analysis of Flight Global Ascend data, with 84 percent more A340s and 150 percent more 777s parked now compared with January.

In Limbo

In China, flag-carrier Air China Ltd. has had between four and six aircraft idle each month in the past year, while SF Airlines Co. has grounded five freighters in the past six months and Uni-Top Airlines Co. has seven out of action, according to Ascend. The number of Rolls-engined planes parked by Asia-Pacific carriers had almost doubled to 30 as of September.

Whatever the price of fuel, airlines will always operate the newest, leanest models, East said. For some older wide-bodies that may mean months in limbo as operators idle them to cut capacity while awaiting an upturn in demand.

East’s comments help explain why he felt compelled to issue the Nov. 12 profit warning, sending Rolls-Royce shares to their biggest drop in 15 years, even after cutting the earnings outlook just days into the job on July 6.

While East threw what seemed like every scrap of negative news into that first communication with investors, he made no mention of the threat to wide-body overhaul revenue. The focus instead was on an ailing market for business aircraft, a slowdown in regional jet overhauls and lower marine-engine sales.

Capacity Mismatch

Sure enough, the CEO said those factors had worsened in his update last week, but none is forecast to approach the impact of the wide-body risk next year.

“Airlines can’t match the capacity and the demand exactly,” East said. “Faced with more aeroplanes than they need to use, they park the less efficient ones.”

The early retirement of older aircraft is particularly bad news for Rolls-Royce and rival engine-makers led by General Electric Co. and the Pratt & Whitney arm of United Technologies Corp., given their reliance on overhaul revenue.

Whereas planemakers make money on new aircraft, engine companies supply turbines at break-even or worse before clawing back costs and booking a profit from maintenance deals that Kevin Michaels, an aerospace consultant at ICF International, said can deliver a 300 percent margin on some spare parts.

Malaysia, Singapore

The drop in utilization of 777-200s and -300s using Rolls’s Trent 800 engine and A340-500s and -600s powered by the Trent 500 has been “unexpectedly steep” as models including the Boeing 787 and more recent 777s and Airbus A330s enter service, according to Agency Partners analyst Nick Cunningham.

Carriers including Malaysia Airlines and Thai Airways International PCL are also reining in their long-haul ambitions amid competition from bigger Asian operators and Gulf carriers, with a switch in focus to regional markets accompanied by a shift to single-aisle aircraft.

Thai Air had idled 30 wide-bodies as of September, up 50 percent in a year, according to Ascend, while Malaysia Air had stood down 11, or seven more.

Asia’s dumping of older wide-bodies comes after Delta Air Lines Inc. said last month that planes coming off lease were already creating a glut, with 777s that sold new for $170 million 10 years ago now fetching as little as $10 million. Singapore Airlines Ltd. has dozens of such wide-bodies coming off lease or retiring soon, the U.S. airline said.

Spares, Totalcare

That valuation means carriers are idling planes or breaking them up for spares rather than selling to other airlines, with both options hurting Rolls’s overhaul revenue, Michaels said. British component supplier Meggitt Plc said Oct. 28 that orders for wide-body parts had stalled, sending its stock down 24 percent.

A further factor that threatens Rolls-Royce’s aftermarket business may be the success of its Totalcare maintenance package, which has limited the availability of third-party overhaul options, keeping costs relatively high for potential second-hand users.  

East says his task now is to slim management, speed decision-making and cut overheads so that Rolls survives its perils to reap a surge in maintenance revenue from an exclusive deal to power Airbus’s latest A350 model.

“The installed base of wide-bodied planes is going to double over a 10-year period,” he said. “The long term trend is there -- it’s just that the capacity has got slightly ahead of the demand.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE