Industrials

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

For any management-minded British engineer, there's no bigger job than becoming chief executive of Rolls-Royce Holdings Plc. Warren East, a well-regarded technology enthusiast, may end up crushed by the size of the task.

East, 55, spent more than a decade transforming U.K. chip designer ARM Holdings into a world-beater. ARM was bought this year by Japan's SoftBank for a staggering 24 billion pounds ($29.4 billion), suggesting he did a good job.

Few would have begrudged him spending the rest of his professional life holding cushy non-executive roles, giving speeches and playing his beloved church organ on weekends. But at Rolls-Royce he's opted for arguably the toughest job in British industry. After a difficult first 18 months, there's little relief in sight in 2017 for the jet engine and turbine maker.

True, a rebound in oil prices may help Rolls-Royce's struggling marine division. Even so, the group probably won't generate much cash flow next year, after an expected outflow of as much as 300 million pounds in 2016.

Cash Constrained
East is under pressure to deliver better cash flow by 2018
Source: Rolls-Royce guidance
Rolls-Royce has guided for up to 300 million of negative free cash flow in 2016. It's said 2017 cash flow will be "marginally positive or negative". In 2018 management's incentive plan implies a target of about 500 million pounds.

While analysts anticipate net income will rise to more than 600 million pounds in 2017, that overstates Rolls-Royce's health because of its odd accounting - of which more anon.

To his credit, East's lost no time slashing costs and cutting jobs and has scored some successes: increasing financial disclosure, speeding up aircraft engine production and dispensing with Rolls-Royce's imperious management culture. But the long development cycles in aerospace mean East isn't entirely the master of his destiny. The Rolls-Royce course was set long before he arrived.

The company's 70.5 billion pound civil order book is focused on the wide-body jet market, where Rolls-Royce is aiming for a 50 percent share. Yet that's a questionable ambition in itself because single-aisle jets are able to fly much further these days and they've sold much better than their fatter brethren.

More important, there's no guarantee that Rolls-Royce's orders, which mostly pre-date East, will ultimately generate lots of cash and profits. One reason for the recent profit woes is that older jets were grounded sooner than managers calculated, meaning Rolls-Royce didn't get the expected service revenues. In view of the huge cost of delivering (and then maintaining) such a large order book it's reasonable to ask whether there's anything else previous management got wrong.

There are other grounds for caution. Last month, East shocked investors when he revealed Rolls-Royce's core civil aerospace unit is loss-making under the more orthodox revenue recognition practices it will have to adopt from 2018.

Deutsche Bank analyst Ben Fidler thinks the civil engine division, which contributes about half of Rolls-Royce revenue, won't make an operating profit until 2019 under the new accounting rules. That will be four years after East first took over.

Furthermore, when the company stops capitalizing engine losses on its balance sheet in 2018, as it's done up until now, shareholder equity could be almost wiped out, according to Credit Suisse. 

Balance Sheet Hit
Rolls-Royce won't be able to capitalize engine losses under new accounting rules
Source: Rolls-Royce
Had it applied IFRS-15 accounting in 2015, Rolls-Royce's shareholder equity would have been reduced by £3.5 billion, before tax. Shareholder equity may change by the time it starts applying IFRS-15 in 2018. This chart is therefore for illustrative purposes only.

Despite those chastening views, Rolls-Royce still trades on 25 times estimated earnings, a hefty premium to French rival Safran SA -- and that's before you adjust for Rolls-Royce's accounting peculiarities.

Such a rich valuation shows investors' faith that East knows what he's doing. But that confidence could evaporate quickly if he can't provide tangible proof that Rolls-Royce's order book is creating value.

A crucial test will come in 2018, when the company has implied it will target about 500 million pounds of free cash flow.  That's going to be tough. East said last month that Rolls-Royce loses up to 2 million pounds on each new engine produced. He may come to regret not spending more time trying to perfect his organ pedal technique.

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

  1. That figure is implied by the management incentive scheme. 

To contact the author of this story:
Chris Bryant in Frankfurt at cbryant32@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net