Rolls-Royce Reveals Entrenched Failings to Stunned Investors

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Image: Rolls-Royce

By Benjamin Katz and Christopher Jasper

(Bloomberg) — Rolls-Royce Holdings Plc Chief Executive Officer Warren East revealed the full extent of the earnings meltdown facing Britain’s leading manufacturing company and said he’s uncovered issues with its organization and management that run deeper than was apparent when he took over in July.

Pretax profit will take a 650 million-pound ($990 million) hit from a slide in demand that Rolls is unable to mitigate because of an inflexible approach to costs, East said Thursday, ordering a review of dividend payments. The announcement extended a series of profit warnings that have battered the company for two years, sending the stock down the most since 2000.

East’s comments come as a further blow to a business that was regarded as Britain’s biggest industrial success story, recovering from bankruptcy to become a poster child of Margaret Thatcher’s privatization drive and take on the likes of General Electric Co. The CEO said he sees no quick fix, effectively writing off a recovery before 2017, when the results of a restructuring plan begin filtering through.

‘Painful’

“These sorts of transitions are often painful, and this one has actually proved to be more painful than anyone expected,” he told reporters. “The fixed costs in this business are simply too high, so that small, relatively modest changes in the top line driven by market conditions just make too big an impact.”

The revelations regarding Rolls-Royce’s organizational malaise suggest the company may be headed for a “classic aerospace and defense near-death experience” that could see its shares drop 80 percent from the peak, Agency Partners analyst Nick Cunningham said.

They came as a shock to investors who had been expecting East to focus his attention on re-evaluating the London-based company’s diversified business portfolio away from power equipment and marine turbines to focus on a record aero-engine backlog.

Rolls-Royce shares fell 147 pence to 520 pence, the biggest drop since Aug. 24, 2000, before trading 18 percent lower at 547.50 pence as of 9 a.m. in London. The stock has slumped 36 percent this year following a decline of 32 percent in 2014, reducing the company’s market value to 10 billion pounds.

‘Completely Unwound’

“The company’s prior push to reduce earnings volatility and surprises looks to have been completely unwound,” Keith Bowman, an analyst at Hargreaves Lansdown Stockbrokers, said in a note. “Rebuilding confidence in the company’s outlook is now paramount for the relatively new chief executive.”

The earnings revision comes after East attempted on July 6 — his second day as CEO — to make a clean break from predecessor John Rishton, who clashed with investors over earnings transparency and key strategy decisions. The newcomer cut full-year forecasts, halted a share buyback and said 2016 numbers would be hurt by slowing sales of engines for smaller aircraft and ships that serve the beleaguered offshore oil industry.

East, who previously ran world-leading semiconductor designer ARM Holdings Plc, will aim to convince shareholders that he can overcome Rolls’s inherent failings when he provides details of a restructuring of its organization and management on Nov. 24. The plan will aim to deliver savings as high as 200 million pounds a year from 2017.

‘Very Challenging’

“The outlook for 2016 is very challenging,” he said. “The speed and magnitude of change in some of our markets, which have historically performed well, has been significant and shows how sensitive parts of our business are to market conditions in the short-term.”

The earnings “headwind” that Rolls-Royce now anticipates next year compares with a hit of 385 million pounds forecast in East’s July update.

Earnings will now be hurt by “sharply lower” sales of corporate jets powered by Rolls engines, together with a more sluggish maintenance market both for those aircraft and bigger regional jets, accounting for 100 million pounds of the increase. Reduced utilization of older wide-body engines will wipe out 150 million pounds beyond prior projections.

“This is essentially capacity management by some of our customers,” East said, adding that even with a lower oil price that’s made more older jets viable by cutting fuel expenses, “if you happen to have already bought an aircraft with more- efficient engines, then you’re going to use it.”

Rolls-Royce is also being impacted by a further deterioration in the market for engines that power marine vessels used by the oil industry, which will weaken 2016 profit by an extra 100 million pounds.

Pretax profit for 2015 will be at the “lower end” of a forecast range of 1.3 billion pounds to 1.47 billion pounds, the company said.

Credit-default swaps insuring the Rolls-Royce’s bonds against losses jumped to the highest since April 2013, a sign that perceptions of credit quality have deteriorated. The contracts rose 6 basis points to 81 basis points in the biggest jump since January, according to data compiled by Bloomberg.

–With assistance from Katie Linsell in London.

©2015 Bloomberg News