Rolls Royce Business Analysis
In 1998 the aero and space market in the United Kingdom was estimated to be £21.6 billion, contributing over ten percent of the UK manufacturing gross domestic product and two percent of the entire GDP. The bulk of the industry lies in military sales, which amounts to almost half of the product sales of the aviation market.1 Military sales have helped companies like British Aerospace (BAE) systems, and Rolls Royce become amongst the UK's largest exporters. The aerospace industry has remained strong in difficult periods through the nineties when there were large defence cutbacks and civil airline cancellations. However, it has been the technical excellence and market positioning that has allowed companies like Rolls Royce to widen the capacity of sales, through associations and relationships with traditional rivals and gained entry into new global markets. This has resulted in the UK industry gaining many domestic and foreign contracts for civil and military defence sales.
For the purpose of this project the definition of the aerospace industry is focused on and includes the sale of aircraft components, parts and engines, refurbishment work, and all after market services. The refurbishments and after market services are often included in company turnover because they are considered future cash flows. It excludes the systems that support avionics such as air and ground controls, their electronics and the electrical systems on board aircrafts.
Rolls Royce has positioned itself as the worlds second largest aircraft maker, closely behind General Electric (GE), but no less a technological leader in the aerospace, marine, and energy sectors of the industry. Throughout recent years the company has built a broader base growing through acquisitions and the expansion of its ample product range. Success has been attributed to the ability to accurately recognize the requirements of world markets and provide outstanding customer and product life support.
The Rolls Royce aerospace business makes gas turbine engines for both military and commercial aircraft worldwide. These customers include armed forces, commercial airlines and corporations who use jets, helicopters, and other aircraft. Rolls Royce is one of the largest makers of marine propulsion systems and both constructs and installs power generation systems, but what many of us know Rolls Royce for are its luxury automobiles.
The British company established in 1906 by Charles Rolls and engineer Henry Royce, had their first unveiling of a car named the Silver Ghost, which earned the makers the title of the best car in the world. Although their primary focus was automobiles, they began producing aircraft engines in 1914 used in the aircraft's of the First World War. These engines were used in a number of historically important flights and in 1931 the Rolls Royce engines set records for speed on land, in air, and by sea. The finest line of automobile today came through the acquisition of the Bentley Company in 1933. It continued to produce engines that powered the fighters of the Second World War. Over the years it has been a pioneer in the aerospace market with its design of the jet engine, turboprop, turbofan, and vertical takeoff engine.2
In 1976 the company penetrated the commercial market of the United States, gaining a presence when it acquired one of its competitors Bristol Siddley, and with it came the contract for the Anglo-French Concorde.
Civil Aerospace
In December 2000, civil aerospace sales amounted to £3,150 million, gaining an underlying profit of £332 million. Engines manufactured by Rolls Royce are used by more than 500 airlines and 2,400 corporate users worldwide. That translates to 31 percent of engine orders placed and a 27 percent share of engines that are delivered, supplying 38 of the world markets top 50. These deliveries have grown from 400 in 1996 to 1,100 in 2000, a record level that is forecasted for continual growth.
"The rapid expansion of our Aerospace business is also creating a growing fleet of engines. As this fleet matures, the company will benefit from the ling term stream of spare part sales and related services." (Sir Ralph Robins, Chairman, annual report 2000.)
Central to this growth are the new Trent family engines, lighter with better payload to range, which translates to higher profit potential, that its competitors.
With operations in 17 countries Rolls Royce has established a competitive advantage through excellence in their customer relations, dependability, and overhaul and maintenance services. The ability to provide after market services for their products with a global network of joint ventures is proven to be at the heart of its success.
Defence
The defence sector of Rolls Royce business had a turnover £1,403 million in 2000, and has been estimated to be worth £130 billion over the next twenty years. Operations have become transatlantic working with a number of major international partners. The United States Department of defence backs three of the four largest projects. Engines are manufactured for many military aircraft including helicopters, fighter jets, and transport vehicles. During the year of 2000 the engine that will power the Eurofighter entered the production stage of which the contract calls for the manufacture of 1,500 engines. Germany, France, and the Netherlands have chosen Rolls Royce engines for up to 399 twin engine helicopters with an estimated value of $1 billion.3
Marine
With the acquisition if Vickers in November of 1999, Rolls Royce has made substantial progress in the marine business. More than 20,000 commercial and naval vessels use engines manufactured by Rolls Royce and they power 400 ships in 30 navies. Again Rolls Royce achieves success through a wide range of products supported by service systems and close customer relationships.
In the naval sector a unique and advanced engine has been chosen for destroyer ships of the Royal Navy. On the commercial market record order levels were taken in 2000 for some 53 offshore vessels that will incorporate Rolls Royce equipment, accounting for 70 percent of all orders placed in the entire industry.4
Energy
There is a growing market for systems used for the generation of power. Deregulation and privatisation of the electricity supply industries and the growing availability of gas are creating greater demand. Rolls Royce recognises these markets and applies its technology in gas turbines and diesel engines to generating power that can be distributed. The company strengthened its position in the oil and gas business in 1999 buy buying the rotating equipment business of Cooper Cameron.5
Following the accepted principal of financial theory, the interest of any company is to make profit. The financial decisions ...
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Energy
There is a growing market for systems used for the generation of power. Deregulation and privatisation of the electricity supply industries and the growing availability of gas are creating greater demand. Rolls Royce recognises these markets and applies its technology in gas turbines and diesel engines to generating power that can be distributed. The company strengthened its position in the oil and gas business in 1999 buy buying the rotating equipment business of Cooper Cameron.5
Following the accepted principal of financial theory, the interest of any company is to make profit. The financial decisions made are therefore based on the principals of capitalism. The objective is to maximise the wealth of the company, which translates into the maximisation of the value of its share, and therefore its shareholders wealth. Shareholders wealth is cash that can be used for consumption of goods and services. It is then maximised by the maximisation of dividend payments expected through time that are generated by the share.
There comes a decision that managers must make in this principal-agent relationship. Financial managers may not always make decisions that will necessarily maximise the wealth of shareholders. Alternatively, it may only aim for a set level of return, for instance an increase in dividends, per annum, of 10%. In a circumstance like this managers may do enough to keep shareholders satisfied, focussing remaining efforts on other, possibly personal objectives. Principals, or the owners of the company's assets, respond to this in two ways. One in which they monitor managers to make sure they are attempting to maximise. The second establishes incentives in which the managers also share in the benefits of maximisation.6
As the agents or managers are employed to manage the assets and capital of the company owned collectively by the shareholders. It is important to consider the sources of the capital that is employed by a company. It is comprised of share capital, capital reserves, revenue reserves, and long term debt. Each of these sources of capital falls under different ownership.
The share capital is the amount paid by shareholders for new shares at their nominal or par value. These are owned by shareholders and are part of shareholders funds and rewards take the form of dividend payments. Capital reserves are also part of shareholders funds and are the amount in excess that were paid for shares. They may also include a surplus on the revaluation of fixed assets. Revenue reserves also called Retained Earnings, are profits that could have been taken by shareholders in the form of dividends that have been left to finance future growth. These too are owned by and are part of shareholders funds.
Long term loans defined as falling due after one years time, are not part of shareholders funds and therefore are not owned by shareholders, they are owned by the issuer or loan provider. The owners of the loan are rewarded with interest payments. These sources of capital are not without cost. Managers and shareholders must evaluate and decide how to structure the capital.
In determining the capital structure of a company, management must decide upon a level of gearing. Gearing, also known as leveraging, is a measure of the level of debt to that of equity. The ratio is given in terms of debt, its value, over that of equity. Rolls Royce had a gearing ratio of 67.67 percent in 2000. In comparison to the previous year, the company experienced a 21.7 percent reduction, in gearing ratios, down from 89.47. This shows that the company has decreased it level of debt in proportion to the amount of its equity.
There are two major ways by which to view the capital structure decision. Analysts Modigliani and Miller showed a number of the effects of increased gearing. The advantages of debt are that it is a less costly form of capital and it brings tax relief. The disadvantages to gearing are that as the level increases so does financial risk thereby increasing the cost of equity. However, in the M&M analysis the end result is a net advantage, where gearing increases and the after tax WACC declines. This analysis suggest that a company should gear up as mush as possible, and those with higher levels of debt to equity will have a greater increase in shareholders wealth.
In opposition to this is the more traditional view, which states there are advantages to gearing but as the gearing level increases a reverse relationship arises and the market value declines. In the real world we see that companies do not tend to follow the M&M theory, taking on extreme levels of debt, and therefore can conclude that there may be factors missing from this analysis. These missing, real world qualities could include bankruptcy costs, agency costs, debt capacity, and tax exhaustion.7
Rolls Royce is a leveraged company. The gearing ratio of its total debt to common equity is 67.67%. The company's total debt figure includes both long term and short term borrowings. The company's equity is comprised totally of ordinary shares, they do not issue preference shares.
In order to estimate the cost of financing ordinary share capital it is necessary to know the dividend policy that the company has adopted.
The most common, and the one in which Rolls Royce uses, is known as the "dividend growth model" or "dividend growth policy". This model assumes that dividend payments will rise at a constant annual rate in perpetuity. This growth rate can be found by taking the average growth of past payments in relation to the number of time periods, assuming that this rate will continue.
Rolls Royce has continued to add value to its shareholders wealth over the past decade. More recently, the five-year historical growth rate has been approximately 10%, with total dividends paid growing from £78 million in 1996, to £126 million in 2000. Turnover and operating profits have also both grown at a rate of 10% in the last five years. For 2001 underlying profits are expected to be flat but are expected to resume growth in 2002.
The company has chosen to follow a stable dividend policy increasing payments by an average of 10% per year. Historically it has been in a strong position, with strong sales and a large order book, to offer its shareholders larger payments. It need not worry about being left with insufficient finance for future undertakings. Any reduction in dividends could lead to the "clientele effect" in which shareholders may view a reduction as a sign of financial instability and therefore look else where for safer and more lucrative investments.
Cost of Equity
By understanding the dividend policy that the company has adopted, and in calculating the average growth rate, we can then go on to estimate the cost of financing ordinary shares. This "cost" is also the return on equity capital form the investors point of view. It is the rate of return that they expect to receive from investing in the company's shares. This can be identified by the capital asset pricing model (CAPM). This is the expected return on the investment in ordinary shares, that is equal to the risk free return plus a risk premium, determined by the market price of systematic risk and the level of risk of Rolls Royce shares.
For the purpose of this report we take management's viewpoint in which this cost represents the minimum return that must be sought when investing shareholders funds. It can then be viewed as the opportunity cost of capital. Either using the CAPM, or in this case using the dividend valuation model can calculate it.
This cost of equity is calculated as the dividend yield for the next year plus the percentage of annual dividend growth. Next years dividend yield is the last dividend that was paid multiplied by one plus the growth rate, divided by the current market value of the shares. Rolls Royce who paid a dividend of 8.00p per ordinary share paid a total of £126 million in dividends for 2000. The company has adopted a growth model with a 10% growth factor and whose shares are traded on the market at 184.25p for a total of £2932 million. Thus, it has an estimated cost of equity of 14.72% per annum.
The method used to estimate the cost of issuing preference shares is identical to that of irredeemable loans. However, Rolls Royce does has not issued preference shares and therefore this does not factor into the cost of equity.
Cost of Debt
Debt capital can be defined as a loan that is made to a company that will be repaid at a future date. This differs from share capital in two major ways. The issuers of debt do not own part of the company, and the payments they receive in the form of interest are a fixed annual rate whereas dividend are not contractually fixed. These payments are placed above equity in terms of payment. With a fixed rate of return, interest payments, a fixed time of payment, and preferential treatment, debt serves as a much less risky form of capital for a company.
Short-term borrowings or amounts falling due within one year consist of overdrafts, bank loans, other loans, and obligations under finance leases. The total short-term borrowings undertaken by the company amounted to £272 million for 2000, down from £408 in 1999. Long-term loans are borrowings falling due after one year's time. These consisted of a number of unsecured bank loans with different interest rates falling due between 2003 and 2016, as well as secured bank loans and obligations under finance leases. Total long-term debt was £1058 million, also down from £1311 in 1999, bringing the total debt figure for 2000 to £1330 million.
The actual cost of debt to the company is estimated by a ratio of interest payments to the total value of the debt. Total interest paid in 2000 was 112 million, divided by the total debt value of 1058 million, yielded the cost of debt to be 10.59%.
Weighted Average Cost of Capital
For the year 2000, total common equity was equal to £2063 million, and total debt was equal to £1330, for a total of £3393 million in capital. The calculation of a company's weighted average cost of capital requires these separate calculations in order to find the weight of each form of capital employed. Of £3393 million total capital employed, a value in equity of £2063 accounts for 60.8%, and £1330 million in debt makes up the remaining 39.19%.
The previous calculations of the costs of equity and debt were independent. They did not take into account their weighted values. A cost of 14.72% in equity, when multiplied by the weighted value of 60.8% yields 8.9%. The cost of debt, 10.59% against its weighted value results in a cost of 4.15%. The company's weighted average cost of capital can now be estimated as the weighted cost of equity (8.9%) plus the weighted cost of debt (4.15%), equalling 13.05%.
Calculating a WACC of 13.05% is an estimation of the rate of return that Rolls Royce should adopt when assessing future project investments. As stated before capital employed also included capital reserves and revenue reserves or retained earnings. The above calculation of the WACC seems to have ignored these factors. However, since both capital reserves and revenue reserves are owned by shareholders they are incorporated into the market price of the shares. In the calculation of the WACC the adjustment of dividend cost in terms of the current market share price accounts for these reserves.8
998
Rolls Royce posted record profits during the second half of 1998. Estimates showed that sales would continue to rise as the result of a boom in aircraft orders during the late 1990's. Supplying engines for plane manufacturing companies, including Boeing's 777 jumbo jet, the Airbus 330, and the Eurofighter, the company posted record income at 260 million pounds, up from £225 the previous year. Earnings per share rose to 17 pence, an 11 percent increase, and paid a dividend of 6.55 pence per share.9
999
Entry into 1999 was promising with rises in sales and net profit. Investor confidence was high with shares trading as high as 288 pence early in the year. March 4, 1999, after a posted 20 percent rise in profits shares began to fall by as much as 5.6 percent. Although the company was reaping the benefits of orders placed in the mid-nineties investors became doubtful that it would continue. Many were concerned that the company was gaining market share at the expense of profit, cutting prices to compete with rivals, number one largest engine maker General Electric, and United Pratt & Whitney.
May 6, shares continued to fall despite winning a contract valued at $300 million, to supply New Air, based in New York, with twenty five Airbus planes. This proved to be a small feat when on July 7, General Electric announced it had won a bid, valued $25 billion over twenty years, to supply Boeing Co engines for their new 777 jetliner. General Electric won the bid over second and third top engine makers, Rolls Royce and Pratt-Whitney respectively.
In late Oct of 1999, things began to pick up with developments in a joint venture with Germany's Bayerische Motoren Werke (BMW). BMW announced it would raise its stake in Rolls Royce from 2 percent, to 10 percent and a $545 million value. Rolls gained full control of the project and with the news came a 29.75 pence rise in share price to around 220 pence per share.
With increased pressure on their margins to gain market share and a reduction in demand from the Boeing Co, Rolls was forced to improve efficiency. On Dec. 10th, the company announced that it would be cutting a total of 1,000 jobs from its England based aerospace unit. With its goal set at reaching a 10 percent increase in earnings for the next year, the company stated it was forced to cut manufacturing costs, therefore reducing its workforce in Derby, England by 7.8 percent.10
2000
With a reduction in its work force and lower demand in the industry shares continued to decline in early 2000. The order book for engines had declined and margins of profit were falling in the aerospace and industrial divisions. While profit at the year's end for 1999 increased 10.1 percent to £284 million, and net income rose from £152 million, to 161 million pounds, analyst's estimates were at £291 million. Shares fell in early March by as much as 13.4 percent to 180 pence in lieu of cash flow worries.11
The market value of shares remained above 200 pence through July. On Aug. 24, the company announced that it would fail to meet its 10 percent increase in earnings for 2001.
"A combination of factors have affected the outlook for 2001, when we now expect underlying earnings to be flat, but the strength of our businesses and the actions taken in 2000 and 2001 will enable earnings growth to resume in 2002." (Sir Ralph Robins, Chairman. Rolls Royce plc. Annual Report 2000, www.rollsroyce.com.)
A 22 percent decline ensued as analysts abandoned Rolls fleeing in numbers. Prudential downgraded their rating of Rolls Royce from a "buy" to "hold", Societe Generale (SA) from a "buy" to "under-perform", and Merrill Lynch moved to a "neutral" position. However, Morgan Stanley Dean Witter took and interesting position in declaring it a "strong buy" placing faith in the company's previous increase in net profits.
A 13.5 percent value was regained over the next week. On the 30th share's rose to as much as 193 pence after Vickers Defence Systems, a company purchased in November of 1999 won a 250 million-pound order from the British Defence Ministry for 66 Challenger tank engines.
In line with the rest of the economy Rolls Royce continued to be pressured by the economic slow down late in 2000. Nov. 9, it declared that it would have to further reduce its work force, cutting jobs from in the Marine, Defence, and Engineering sectors for a total of 1,300 jobs. This following the announcement in August that they would not be able to meet expected earnings.12
2001
As the world economy dragged itself into the first year of the new millennium, Rolls Royce sought to secure itself a place in the world market of engine makers. Things began to pick up in April when the company unveiled a deal to provide the United States Navy and Coast Guard a range of products and services including ship engine building and maintenance. Allowing president of the Rolls Royce Marine sector, Saul Lanyado, to boast of the company's global spread serving thirty navies worldwide. Share value began to increase steadily through May reaching a spike of close to 295 pence in June. Share market value would see a decline although remaining healthy through July and August.
Leading economic indicators in global markets and composite indexes for August of 2001, showed signs of weakening economies around the world. Stock prices, vendor performance, interest rates, a growing unemployment rate and consumer expectations all showed major countries including the United States, the UK, and many Asian territories heading for recession. Entertainment and air travel industries were already suffering decreasing traffic. Analysts had a number of outlooks for the future. Non of them would be able to predict the economic blow that would serve as a catalyst for further deterioration.
Suffice it to say that the attacks on September 11th were unspeakable. They came at a time when the world's economy was already in a state of erosion. Estimates in October declared that the attacks would "siphon $350 billion out of the world's economy" by the end of the year. Ian Kinniburg, Director of UN Development of Policy Analysis said it would trim world growth a full percentage point to 1.4 percent.
Very few industries, if any at all have not been affected by the attacks. Rolls Royce is no exception. As the world waited with held breath for the markets to open in New York, many institutions around the world could do nothing but wait. No one could know what was going to happen although many could predict that fear would spawn massive liquidation. One thing for sure, areas to avoid included the airline stocks and insurance industries.
September 14, UK stocks began to fall, the plummet lead by British Airways and Rolls Royce. The FTSE 100 Index fell 5 percent or 22 points, British Airways by 17.75p and Rolls Royce by 7.5p to 174.25. With fear and concern that the US would enter into war with oil producing countries oil prices rose, both BP and Shell climbing 2.2 and 3.5 percent respectively. By September 17, UK stocks had experienced their steepest decline in 14 years with the FTSE 100 falling a total of 28 points, and a slide in Rolls Royce of 18.5p to 147.
By Oct. 14 Rolls would pronounce that it would have to cut another 3,500 employees due to the slowdown of sales as a result of the attacks. Shares fell further to 133p. Boeing also announced it would let go of 12,000 of its employees by the end of the year, Merry Christmas. Losses for Rolls will come as older planes are grounded and taken out of service. It is in the after sale overhauls and maintenance services that the company makes its greatest profits. The initial sale yields a small return, but as planes get older they require more maintenance and this is were Rolls makes its money.
As markets began to recover slowly, Rolls also began to make a strong recovery, all things considering. However, when it seemed like the situation couldn't get any worse, reports that another American Airlines plane had crashed on Nov. 12, US and UK markets falling again. The benchmark FTSE 100 fell 84.9 points, British Airways plunged, and Rolls Royce slid back down to 160.13
Rolls Royce shares fell a total of 40 percent between the Sep.11 attacks and Oct.2. The airline industry continues to suffer from little demand in air travel. Airlines have begun to retire old planes depriving Rolls of earning sales on maintenance. The market share value has regained about 20 percent of its pre Sep.11 value, and is currently trading at 177.26 (December 8, 2001).
As global competitor, Rolls Royce is exposed to certain financial risks associated with movements in different global markets. It uses various financial instruments to protect itself from these exposures that may arise. The risks most apparent with movements in financial markets are those in foreign currencies, interest rates, and commodity prices. The company does not trade instruments for profit, only for managing risk. To hedge these risks the company uses a number of derivatives including jet fuel swaps, interest rate swaps, currency options, and forwards foreign currency options.
Movements in exchange rates of foreign currencies effect both foreign transactions and the conversion of profit and loss accounts. The most significant exposure is that of the US dollar to Sterling. US income accounts for 42 percent of its UK turnover. The company covers its exposure through the continual hedging of standard foreign exchange contracts and currency options against their dollar income. In fact, risk managers tend to use covered option writing as a means of protection.
"We do believe that buying and writing of options can complement our hedging policy... We will in no event ever write options if there is no requirement to have the underlying there in the first place... that is we will not write naked options."(Mark Morris, financial risk manager, "No Fear of Options Here," Corporate Finance, July 1994, p. 44)
A point of interest lies where Rolls Royce sells sterling puts on the dollars its receives as income. To sell a put when it already has a forward position seems to be somewhat equal to a call option.
The company manages its interest rate risk by using interest rate swaps to change fixed rate borrowings into floating rate borrowings in order to match the rates of short-term bank deposits.
Commodity risk includes the company's sensitivity to changes in the price of jet fuel. In order to best hedge against changes in the price of jet fuel it has entered into jet fuel swaps.14
The following report was written with the intent of displaying the financial position of United Kingdom Rolls Royce Plc. An analysis is given using company reported data spanning from January 1996 to December 31, 2000, and statistical data up to the week of December 4, 2001. Market values are based on share price taken November .......The report uses information and has derived calculations from the annual report of 2000. These calculations include that of the dividend policy and growth rate, cost of capital, both equity and debt, and their weighted averages. These calculations, although limited in depth, are fundamental in analysing the company's current financial capital structure.
Bibliography
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3. "No Fear of Options Here", Corporate Finance, July 1994.
4. Lumby & Jones, Investment Appraisal & Financial Decisions. Third Edition, 1999.
5. "News Scan P.M.: Oct. 25, 2001", forbes.com staff, www.forbes.com.
"News Scan P.M.: Oct. 25, 2001", forbes.com staff, www.forbes
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9 Bloomberg Professional, RR / Equity Headline News.
0 Bloomberg Professional, RR / Equity Headline News.
1 Rolls Royce plc. Annual Report 2000, www.rollsroyce.com.
2 Bloomberg Professional, RR / Equity Headline News.
3 Bloomberg Professional, RR / Equity Headline News.
4 Rolls Royce plc. Annual Report 2000, www.rollsroyce.com.