Rolls-Royce Must Keep Spending

East's room to maneuver is limited by R&D budget

Rolls-Royce's new chief executive Warren East thinks the British aircraft engine-maker has become bloated in its old age. He intends to put it on a crash diet to end the malaise that has forced the company to issue a string of profit warnings.

Bad Year

Bloomberg Data

The only problem is that the need to continue spending on research and development -- a perfectly natural endeavor for a technology-led manufacturer -- limits his room for maneuver.

Rolls-Royce books about 13.7 billion pounds ( $20.5 billion) in annual revenues but 4 billion pounds of that vanishes on stuff not spent directly on making or delivering products to customers. East announced a management reshuffle this week to help slim down Rolls Royce's top-heavy organisation and save 150-200 million pounds in yearly costs by 2017.

But East has ring-fenced R&D, which he views as the seed of Rolls Royce's future sales and profits. The trouble is, R&D has become such a large proportion of operating expenses -- almost 800 million pounds last year or roughly four times the cost-saving target -- that funding all those big brains is eroding the company's ability to generate cash flow.

According to Bloomberg data, Rolls-Royce's operating expenses as a percentage of sales have increased steadily over the past four years. But as the chart below shows, this growth has come from an increase in R&D spending. Over the same period, general and admin expenses, something you would associate more readily with a bloated corporate structure, has actually declined as a proportion of revenue.

Rolls-Royce R&D Costs

Bloomberg Data

The company has been investing heavily in developing new engines such as the Trent XWB-97 and Trent 7000, which are destined for the new Airbus A350 and A330neo respectively. It's also plowing cash into futuristic aero-engine designs such as the Advance and Ultrafan. The latter has a fancy, geared design and carbon titanium fan system and should be ready by 2025.

As some development projects reach maturity Rolls-Royce accountants will be able to capitalize R&D costs on the balance sheet, rather than expense them. Yet management is still guiding for at least 750 million pounds of net R&D spending in 2015, a figure that probably won't fall in subsequent years. With revenue expected to decline this year and next, that means it's likely to remain inflated as a percentage of sales. 

Indeed, if Airbus decides to overhaul its A380 superjumbo, it's conceivable Rolls-Royce will have to invest even more. R&D is therefore a cost lever that East is unable to pull as he tries to stem a cash shortfall due in part to weaker-than-expected after-market income from ageing wide body aircraft.

There's also the argument about whether the company has been spending its development budget wisely: for example, should it have invested in narrow-body engines or doing more in corporate jets?

In fairness, the recent R&D splurge has been the result of winning contracts to supply major aircraft such as the A350 and A330neo. Had it lost out to rivals, it could now slash development costs and profits would go up (before collapsing a few years later). The hope is that one day, the new engines will start delivering handsome after-market fees.

But because of Rolls-Royce's nasty habit of springing earnings surprises, the market has lost confidence in those long-term aims and the reliability of future cash flow. East's challenge is to change that perception by making the company a far leaner outfit. The R&D conundrum shows that won't be easy.

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

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