Rolls-Royce roars again

Warren East
Warren East: winning the fight

Chief executive Warren East has pulled the jet-engine firm out of its nosedive. Investors will now be expecting a higher dividend. Alice Gråhns reports.

When Rolls-Royce boss Warren East took over three years ago, “many predicted a short, unsuccessful reign”, says Ben Marlow in The Daily Telegraph. The business “had been brought low by a massive bribery scandal”. Eight profit warnings followed, the share price halved in three years and Rolls racked up a £4.6bn annual loss in 2016, the worst in its long history. But now, “after a long, painful struggle”, East appears to be winning the fight to turn the firm around.

Rolls bounced back in 2017, producing a £4.9bn operating profit. Underlying profits jumped by a quarter to £1bn and free cash flow has almost tripled to £273m. This year it should reach £450m, and East reckons it will exceed his target of £1bn by 2021. The shares rose 15% last week on the news. So how did East do it?

“Old-fashioned cost-cutting” was the crucial first step, says Marlow. He has got rid of 600 executives and senior managers. That will make it easier to streamline the company’s structure, with five divisions being reduced to three: civil aerospace, defence and power systems.

Rolls squeezes its customers

Meanwhile, “if you’re a customer of Rolls-Royce, there’s a fair bet you got a call toward the end of last year, politely asking you to pay your bill”, adds Chris Bryant in Bloomberg Gadfly. The group has been under pressure to show that it can generate more cash. Last year Rolls spent £550m on improving working capital management – “short for getting customers to pay up” – which was a big reason why free cash flow jumped so strongly.

A £2.6bn non-cash uplift from hedging contracts also flattered the result, notes Lex in the Financial Times. Meanwhile, “industry dynamics” are providing a tailwind. Rolls’ aircraft engine sales are expected to rise from 4,400 to 6,000 over five years. “Jet engines are loss leaders for [engine] service contracts.” “As upfront costs roll off, lucrative service revenues should rise.”

The “positive trend is unmistakable”, says Liam Proud on Breakingviews, which means that “one of the last vestiges of Rolls-Royce’s tumultuous recent history – its reduced dividend – may come to an end”. East kept the payout steady at 11.7p per share last year; the total distribution of £216m sucked up 80% of free cash flow.

Before last week’s results, analysts had pencilled in a 2018 dividend of 12.9p per share. That implies a payout of £240m – just 53% of East’s free cash-flow target of £450m for the year. Dropping the payout ratio “would look odd at a time when profitability and cash flow are on the up”. East has announced an investor day for the early summer. We can expect the group’s “roaring cash engine to be top of the agenda”.


GKN bid battle enters final stretch

“Finally, all the cards are on the table in the humdinging takeover battle for GKN,” says Jim Armitage in the Evening Standard. Takeover specialist Melrose has raised its offer for the engineer by 11% to £8.1bn, taking it to 467p a share. The target’s bosses think their company is worth at least 500p.

GKN’s boss Anne Stevens (pictured) has “arguably been demonstrating the greater tactical nous of late,” says Matthew Vincent in the Financial Times. Her defensive tactics have broadly succeeded. She has said the right things about margins; promised shareholders £2.5bn from disposals; set out a timescale for splitting automotive and aerospace divisions to realise value; and attempted to secure a “bid-blocking” deal with US rival Dana.

Melrose insists that its experienced management is a better bet than a GKN break-up, says Aimee Donnellan on Breakingviews. As far as price is concerned, meanwhile, it is “not being reckless”. The higher bid values GKN at about 8.5 times expected earnings before interest, tax, depreciation and amortisation for this year, after including net debt and the firm’s pension liabilities. If it manages to double GKN’s operating profit margin, Melrose will still double its investment by 2022. Now GKN investors have just two-and-a-half weeks to make up their minds.

If they back management, they risk ending up with US shares, no control over Dana’s automotive strategy and an unproven team to turn the group round GKN aerospace, says Vincent. With Melrose, “there’s the safety of a… simpler deal, proven management and some actual cash”.


City talk

• This week Aviva “lobbed a rocket at its preference shareholders”, say Chris Hughes and Marcus Ashworth in Bloomberg Gadfly. The insurer is considering cancelling its preference shares and paying back investors at par value. The price of the securities, which had been trading well above par, collapsed. Ordinary and preference shareholders will have to approve the proposal. But given it would save Aviva about £40m in interest annually, expect ordinary shareholders to back the plan – and their votes outweigh the preference holders’ votes. These securities, “highly valued by individual investors and pension funds”, look “increasingly like an endangered species”.

• Paul Flowers, ex-chairman of the Co-op Bank, is not “fit and proper” to work in UK financial services, says the Financial Conduct Authority (FCA). That verdict is not due to the £1.5bn black hole that sprung up on Flowers’ watch, says Alistair Osborne in The Times. No, it was that Flowers (pictured above) rang premium-rate chat lines from his work phone and used his email account to transmit “sexually explicit” messages and discuss illegal drugs. But why has it taken the FCA four years to come up with “the most obvious of bans”?

• Insurance giant Prudential is to demerge the UK business M&G Prudential from the overall Prudential group, resulting in two separately listed companies with their own strategic rationale, says Matthew Vincent in the Financial Times. Investors will now be able to decide whether they want to back a FTSE 100-listed UK and Europe savings and investment provider, or Prudential the international insurance group, concentrating on faster-growing markets in Asia, Africa and the US. They are no longer obliged to bet on both.