Industrials

James Boxell is an editor with Bloomberg Gadfly. He worked previously at the Financial Times in a variety of writing and editing jobs. Before becoming a journalist, he helped launch a legal technology startup.

When Warren East issued a profit warning in his first week in charge of Rolls-Royce in July, it looked like one of those kitchen-sinking exercises popular with incoming CEOs who want to start with a clean slate. If only.

Yet another warning arrived on Thursday, when the British industrial stalwart said next year's earnings will be cut by 650 million pounds ($990 million) because of falling demand for corporate jet engines and lucrative maintenance work from the owners of large passenger aircraft.

East, the former boss of U.K. chipmaker Arm, said he's confident about the long-term prospects for what was until recently one of the few U.K. engineering success stories. But in the medium term, things will get worse.

Rolls's Repair Job
Source: Bloomberg

After concluding that the company's fixed costs are too high and make the company too inflexible to adapt to rapidly changing aerospace markets, East has promised savings of as much as 200 million pounds a year by 2017.

His problem is that everywhere he looks there are demands for investment.

It's now clear that Rolls-Royce's decision to exit an engine partnership for narrow-body aircraft engines with Pratt & Whitney wasn't the smartest of moves ahead of a boom in orders for Airbus's re-engined A320neo and the competing Boeing 737MAX. But any decision to reverse that move will require big upfront development costs and put more pressure on medium-term profit and cashflow.

On top of this, the European Union is looking into the business models of engine makers and their control of the aftermarket for service and repairs. This is a worry because it's a crucial part of the Rolls-Royce business model that's already under pressure as pricing power shifts from engine suppliers to aircraft makers Boeing and Airbus.

The company's travails have opened the door to investors such as ValueAct, now its third-biggest shareholder. While it supports East, the activist may push eventually for disposals. The marine engine business is a prime candidate, although East has so far backed his predecessors' diversification strategy as the best way to cope with cyclical downturns in aviation and defense. Plus it's hardly a good time to sell the marine unit given a large part of its revenue is linked to the depressed oil and gas industry.

On the plus side, Rolls-Royce has said cash flow will be largely unchanged over the next couple of years, while the balance sheet is healthy. Engine-making is one of the longest term businesses out there and Roll-Royce still has world-beating technology that's tough to replicate. East did a good job managing a tech company at Arm, and it's hoped he'll bring some of that industry's nimbleness to an old-world manufacturer.

But investors waiting for his repair and overhaul job to start to pay off really will need to be in it for the long haul. Even someone with East's gifts will struggle.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
James Boxell in London at jboxell@bloomberg.net

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Edward Evans at eevans3@bloomberg.net