Keep your friends close -- and potential enemies closer.
That's advice Rolls-Royce has taken to heart by giving ValueAct, an activist investor and its largest shareholder, a seat on the board. So far the two sides have avoided a confrontation. But can the peace last?
Inviting ValueAct to join the table of the UK's flagship industrial company isn't a step to take lightly. Rolls-Royce Chairman Ian Davis says the board's views are aligned with those of ValueAct and only a couple of investors were "uncomfortable" with the decision.
It's still a canny one. Sensible boards are discovering it's better to bring an activist shareholder inside the tent and listen to their views -- rather than fight a public campaign. Look at Alliance Trust's failed attempt to resist Elliott Advisors' calls for an overhaul. Or Electra Private Equity's failed fight against York-based Edward Bramson. Both companies eventually lost to the activists and their chairmen departed.
As a director, ValueAct's Bradley Singer is obliged to act in the interests of the whole company, rather than pursue his own narrow agenda.
There are 14 other members of Rolls-Royce board -- many of whom are likely have strong views of their own. If Singer makes constructive suggestions that generate shareholder value, then so much the better for all investors. If not, he should be reminded he is but one member of a large team.
The problem for ValueAct is that any turnaround in Rolls-Royce's fortunes will take a long time, longer possibly than the fund's own investment horizon of about three to five years. The British company faces a tricky transition period before a new generation of aircraft engine hit their stride.
Rolls-Royce CEO Warren East is cutting costs, a policy ValueAct doubtless supports, but operating profit is expected to fall by half this year and recover only slowly in the years thereafter.
Rolls-Royce also has little choice but to keep spending large sums on research and development. It could therefore take until the end of the decade before the company really starts to purr again. ValueAct's much-vaunted patient style of activism will be put to the test.
It wouldn't come as a surprise to learn that ValueAct would prefer for Rolls-Royce to focus more on making aircraft engines (which contributes more than half of operating income) and less on, say, its marine business, which has been hit by the falling oil price (and contributes only 1 percent of operating profit), as some media reports have suggested.
But East hasn't shown much sign of wanting to shake-up Rolls-Royce's capital allocation priorities fundamentally. The company is in the midst of an operational review -- but a break-up seems unlikely. Rolls-Royce better hope ValueAct can live with that.
The fund's stance if a takeover approach were to be made for Rolls-Royce is also hard to read. ValueAct's investment in oilfield equipment maker Dresser-Rand was followed swiftly by its sale to Siemens. But the U.K. government, which holds a golden share in Rolls-Royce, would in all likelihood have strong reservations if United Technologies were to make an approach, as Gadfly has argued might make sense.
For now, Rolls-Royce's tactics are hard to fault: Davis is postponing a battle just as the company is in its weakest position to fight one. But the risk that day will come still hasn't gone away.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Corrects number of board members in sixth paragraph)
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