In the beginning of this new year, investors in Rolls-Royce who have not had much to cheer about in the past are now in a good mood.
The Stoxx 600, Europe’s biggest listed companies, will see the FTSE Engineer’s share price rise by 224 percent to 299.7p in 2023, its best performance since 1987 when the company was privatised.
The dramatic change in fortunes of the company on the stock exchange coincides with the arrival in January 2023 of the new chief executive Tufanerginbilgic. This oil industry veteran took over the reins at Rolls-Royce with a mandate for improving performance and driving down costs.
He has been publicly and brutally honest about Rolls-Royce’s shortcomings. He has shaken up the senior management and announced job cuts, as well as set ambitious targets for financial performance.
Investors and analysts alike have embraced the turnaround story. Even longtime bear David Perry, of JPMorgan who, in December, gave the stock an “overweight rating” for the first since October 2014.
Perry said, “I’ve never seen a CEO make such an impact in such a brief period of time.”
“The recovering market conditions has helped, but much was expected a year ago.” We believe that the majority of improvements in Rolls-Royce 2023 performance will come from its. . . Erginbilgic’s team and he have taken initiatives to achieve the new financial targets,” he said.
Many people are enthusiastic about the new CEO, but others want to point out that he is not only credited with bringing greater cost discipline into the company, but he also had a good timing, as evidenced by the recent dramatic increase in travel worldwide and the increased spending on defence by governments.
The majority of the company’s revenue comes from long-term maintenance agreements for its passenger jet engines. In addition, the improvement in international air travel in Asia-Pacific has led to an increase in cash flow.
Former industry executives said that “he has a strong following wind due to increased flying, the strong US dollar and strong defence [spending], and little new product spending.” They said it was hard to know what effect his actions had already.
Rolls-Royce has been restructuring for many years. In the recent history of this 117-year old company, successive turnaround plans have been launched by various chief executives.
It is known for its large jet engines, but also for the turbines it makes for fighter aircraft and nuclear submarines. The group also produces gas and diesel engines for power generation and ships.
Rolls-Royce has historically had lower operating margins than its larger competitors, such as General Electric of America. In recent years, Rolls-Royce has sacrificed profitability to gain market share against rival engine manufacturers.
The company was particularly hard hit by the pandemic of coronavirus because it focuses on engines for widebody aircraft which fly long-haul. This segment of the industry has suffered due to the decline in international flights.
Erginbilgic, who succeeded his predecessor Warren East in the role of CEO, had a reputation for being a formidable operator. Priorities were to cut losses in the engine business and to make sure that the costs incurred during restructuring didn’t creep back into the equation once the market recovered.
He has acted quickly to put his stamp on the organisation; almost half of Rolls-Royce’s senior executives, including former chief financial officer Panos Kakoullis, have changed positions or left as part of the restructuring and his move to centralise core functions such as human resources and purchasing.
Erginbilgic is keen to emphasize a turnaround that is led by the company, rather than relying on the market.
It is our actions which drive the performance. He said that it was not the environment at the capital markets day of the company in November, where he set new midterm goals for operating profit up to £2.8bn in about 2027. This is four times what the company reported in 2022.
Erginbilgic stated that the targets “actually represent a step-change in performance”. He noted that the company had upgraded its 2023 guidance when it released its half-year results back in August.
He said that the cash flow and operating profit numbers would be our best ever, with engine flying hours still around 86%.
As part of its mid-term plan, the group aims to increase operating profit margins from 2.5 per cent to 15-17 per cent. It expects operating margins in its core civil aeronautics business to reach 15-17%, up from 2.5 percent in 2022. This would put it on par with rivals like GE.
Nick Cunningham of Agency Partners said that the “underlying increase in engine flight-hours and underlying revenue increases from long-term agreements are not surprising”, noting “China reopened [at the start of 2023]”.
Erginbilgic is credited by Cunningham with setting the foundation for future success. Cunningham said that Erginbilgic’s efforts to improve contract structure and financial discipline, such as managing working capital or not signing new contracts, will pay off in the long run.
Graeme Forster is the portfolio manager of Orbis. Orbis bought Rolls-Royce stock about seven years back. He believes that Anita Frew, Rolls-Royce’s “no-nonsense chair”, deserves some credit. Frew appointed Erginbilgic and has overhauled the Board since her own arrival in October 2021.
Forster also praised East for ensuring the company survived Covid, and launching his own restructuring program, which included 9,000 job cuts to save £1.3bn.
Insiders at the company say the outlook for the near future is positive. The latest commitment from Turkish Airlines, to purchase over 200 Airbus planes, including A350s powered by Rolls-Royce engine, will make 2023 the best year in 15 years for Rolls-Royce.
Rolls-Royce’s upgrade to investment grade status by all rating agencies will be a crucial marker of success. S&P Global upgraded the company to BB+ status in December. Analysts believe that a new shift upward could occur relatively soon. This could pave way for the company’s return to dividends.
Engineers’ balance sheets will also benefit by not having to invest heavily in a new engine over the medium-term. Rolls-Royce still faces a major strategic question: How can it enter the lucrative market of engines that power narrow-body commercial aircraft?
The company pulled out of a US joint venture with Pratt & Whitney more than a ten years ago.
Erginbilgic made a big deal about the fact that it could use the new engine technologies developed by its UltraFan program to work with a different supplier. The group’s next-generation UltraFan engine is aiming to be 25% more efficient than its first Trent engines.
It remains to be determined whether Erginbilgic, who is 64 years of age, will stay the course or if it will be a difficult task for his successor.
Rolls-Royce will now focus on meeting these new targets and improving its earnings margins in long-term agreements with airline clients.
In order to get there, it will need to increase prices, reduce costs and improve the “time on the wing” or durability of its aircraft engine so that they can fly longer before requiring maintenance.
JPMorgan’s Perry said that Rolls-Royce R&D engineers “focus on improving time on the wing” now. Perry, a JPMorgan analyst, said that Rolls-Royce’s R&D engineers are now “focused on improving time on wing”. . . If Rolls-Royce wants to reach its goals.”