A Giant of the Skies Is Flying On One Engine

(Bloomberg Opinion) -- The decision by Rolls-Royce Holdings Plc to cut about 9 percent of its workforce prompted one big question on Thursday: Why now?

Warren East took over as chief executive three years ago with a mission to transform the productivity of the aircraft engine-maker and to deliver on an unprecedented rollout of new engines. During his short tenure there’s already been plenty of upheaval, including thousands of job cuts. Arguably the last thing Rolls-Royce needs right now is yet more disruption. Airline customers are furious about technical troubles with its Trent engines that have grounded Boeing 787 planes.

East insists that the cuts, expected to deliver 400 million pounds ($537 million) in yearly savings, have nothing to do with those problems and won’t affect customers. Perhaps, but it’s hard to escape the feeling that he’s reaching for the ax not from a position of strength, but one of weakness.

The CEO is admired by analysts and investors and most have kept faith with Rolls-Royce even though it generates pretty feeble profit and cash flow at the moment. In return, East has offered them a branch to grab hold to. Come hell or high water, he will deliver 1 billion pounds of free cash flow in 2020.

The company has stuck resolutely to the goal, as well as this year’s target of roughly 450 million pounds of free cash flow – despite about 580 million pounds of unexpected costs in the next two years for fixing its Trent engines. 

While job losses are horrible for those affected, investors stand to benefit – in theory. If implemented as planned, the cuts should allow Rolls-Royce to deliver at least 40 per cent more free cash flow in 2021, implying several billion pounds of value creation. Yet a relatively modest 2.6 percent bounce in the share price after the announcement suggests investors are skeptical, worrying that some savings will be consumed by other bits of the business. 

This famously bureaucratic company does have too many layers of management and surplus administrative staff. But it’s puzzling why, if these workers are so clearly surplus to requirements, East didn’t make bigger cutbacks sooner.

Rolls-Royce’s personnel expenses don't look that high and selling, general and admin expenses haven't risen in five years, despite a more than 10 percent revenue jump over that period, according to Bloomberg data. Rolls-Royce made 2,600 job cuts in 2014 just before East arrived.

Pushed for further justification of the new cuts, East pointed to last year's 273 million pounds of free cash flow. That means its cash yield (a measure of cash flow as a proportion of market value) was just 2 percent.

But the chief cause of this poor performance isn’t too many human resources staff or number crunchers, it’s more that Rolls-Royce doesn’t make enough money building and servicing engines. Even that modest 2017 cash flow relied heavily on a big swing in working capital, while profit was flattered by a helpful decision to start capitalizing more R&D spending.

Slashing fixed costs is one thing, but the Rolls-Royce path to salvation lies in reducing losses on engine sales, lowering servicing costs and making sure customers’ planes stay in the air. Rolls-Royce fees are linked to flying hours. Right now, it’s having trouble with the latter, and investors can't be sure that more problems won’t emerge. Perhaps that’s the reason for the discount they’ve applied to the promised cost savings.

Meantime, the bounteous cash flows from the service business remain a promise rather than a certainty. Even after he’s finished telling thousands of employees why they no longer have a job, East will still have plenty more explaining to do.

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

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