Pandemic-hit Rolls-Royce hopes for clearer skies as new boss takes helm

Rolls-Royce has faced its fair share of turbulence over the past two years as the British aerospace engineer came close to collapse during the Covid-19 pandemic. More upheaval is on the horizon with the arrival of new chief executive Tufan Erginbilgic.

Investors and analysts expect the 63-year-old oil industry veteran, who took over from Warren East at the start of January, to launch a strategic review alongside the company’s full-year results next month.

Rolls-Royce, whose civil engines power some of the world’s biggest jets for Airbus and Boeing, took a big financial hit from the grounding of flights during the pandemic. East embarked on a sweeping restructuring programme, including 9,000 job losses, to save £1.3bn in costs, and had to shore up the group’s balance sheet with £7.3bn of new equity and debt.

Progress has been made. The company has repaid £2bn of debt, with about £4bn of drawn debt outstanding. It is on course to have met its financial targets for last year, including generating “modestly positive” free cash flow and mid-single-digit underlying revenue growth, but it remains a long way from firing on all cylinders.

Investors want Erginbilgic, who earned a reputation as a seasoned operator with a focus on performance and driving down costs in his previous jobs at oil group BP, to attempt the same at Rolls-Royce. Improving the performance of the civil aerospace division, which still generates 40 per cent of the group’s underlying revenues, is key.

Clear priorities are reducing the losses when the company makes and sells an engine, as well as ensuring that costs taken out during the restructuring do not creep back in once volumes return as the industry’s recovery gathers pace.

The Turkish-British national has already visited Rolls-Royce’s main operations in Derby in the UK, Indianapolis in the US and Friedrichshafen in Germany, according to people familiar with the situation. A meeting with union representatives in Derby is scheduled for late January.

“He has certainly brought a sense of urgency with him,” said one of the people.

He is not afraid to stir things up at the 117-year-old company, either, demonstrated by his invite to longtime bear of the stock — analyst David Perry of JPMorgan — to deliver a presentation to the company’s senior leadership earlier this month, according to people with knowledge of the matter.

Rolls-Royce declined to comment, as did Perry when approached by the Financial Times.

In his latest analysis of the company, published at the start of January, Perry predicted that Erginbilgic would offer a “hard-headed analysis” of Rolls-Royce’s “current strategy and financial position”.

According to Perry, the company’s situation was one where the recovery in engine flying hours — a key metric and generator of cash flow as Rolls-Royce is paid by the hours that its engines are in the air — had been much slower than expected, free cash flow was also weaker than expected and its balance sheet remained strained.

“We think he will prepare investors for either further restructuring or measures to improve the balance sheet,” said Perry in the note, adding: “In short, we believe near-term pain will be needed to achieve long-term gain.” 

Simon Skinner, head of European investments at Orbis, which bought into Rolls-Royce shares in 2015, said Erginbilgic’s priority “has to be to get the company back on to a firm financial footing”. 

He believes the company could be “much more commercially sharper” and needs to make sure it receives “appropriate value for its services”. Rolls-Royce, he added, had “prioritised customer service over company profitability” and needed to find a “better balance”.

The company, which has taken out costs from its civil aerospace division, also needs to ensure they stay out as engine flying hours rise with the opening up of travel.

Large-engine flying hours have been recovering steadily but were still just 65 per cent of pre-pandemic 2019 levels in the four months to the end of October, Rolls-Royce said at the time.

The recent lifting of Covid-19 restrictions in China, however, and the reopening of Chinese airline flights, as well as those in and out of the country, will help boost flying hours.

“As China unlocks, there will be a significant snapback of air travel demand. For Rolls-Royce, China and proxy-China represented just over a quarter of total engine flight hours in 2019, pre-Covid,” said Charlotte Keyworth, analyst at Barclays.

“There is a 70 per cent correlation between engine flying hours and the company’s share price, so this unlock is significant.”

Given the difficulties that Airbus and Boeing are having in ramping up production of new aircraft amid supply chain constraints, analysts also expect that a significant number of aircraft currently in storage will be returned to service, generating revenues for Rolls-Royce. Some of these will be Rolls-Royce powered widebody aircraft such as A330s.

“Except for long-haul, civil aerospace is trending towards long-run growth again but in a difficult macroeconomic environment. A lot of the long-haul recovery is still to happen and Rolls-Royce is the purest way of pursuing that,” said Nick Cunningham of Agency Partners.

Any strategic review launched by Erginbilgic will have to consider how to position Rolls-Royce for a net zero world.

Under East, the company has invested in new business areas of electric aircraft and small modular nuclear reactors to underline the fact that the company should be seen as more than a maker of fossil-fuel burning engines. While investors believe they represent potential growth markets, they want Erginbilgic to focus on those that will make money for the company.

No imminent decision is expected on whether to divest the company’s Power Systems business whose engines propel ships and trains. Rather, the focus is expected to be on improving its operational performance first.

Other strategic questions such as finding an industrial partner for the next-generation propulsion system are also expected to be tackled at a later date.

Orbis’ Skinner admitted that “it’s been pretty bumpy” over the past seven years as a shareholder but insists that patience will be rewarded and that “decent returns” are possible. Despite the challenges, Erginbilgic’s tenure may also benefit from timing given the reopening of China.

“He could just be fantastically lucky with the market in civil aerospace,” said one industry watcher.