Rolls-Royce’s new CEO sets sights on the long haul

Warren East, the new chief executive of aero-engine maker Rolls-Royce, knows more than most about the clash between short and long-term interests in a business.

“Warren says he spent his whole time at Arm Holdings being pressed by banks and investors to sell the business in its early stages,” explains a Rolls-Royce board colleague. East — who was chief executive of Arm, the UK semiconductor designer, for 12 years — held out against these demands and the company eventually went on to dominate the global market for microchips in mobile devices.

“That is a good example of saying no, we can make more value by running this business ourselves,” the director says. “Our job at Rolls-Royce is not to allow short-term pressures to undermine the long-term value of the business.”

But that is a challenging task after four profit warnings in 18 months and calls from some investors for the engineering group — which spans land, sea and air power systems — to focus its efforts on aerospace. Now, the emergence of a US-based activist fund as one of Rolls-Royce’s top shareholders has only heightened the pressure for a disposal of the poorly performing land and sea businesses.

California-based ValueAct has indicated that, while supportive of East, it will eventually push for disposals.

East, however, has said he believes Rolls-Royce’s diversification strategy is “broadly correct” — potentially setting up difficult conversations later.

Many inside the company, and some investors, also appear sceptical of ValueAct’s apparent conviction that there is no need to have other businesses to counteract the 20-year cycles of Rolls-Royce’s biggest market: the passenger aircraft industry. As one board member puts it: “Risk increases massively the more pure play you are.”

But the market is not sympathetic. “It is hard to persuade investors of the merits of a strategy that is meant to bring rewards starting in the 2020s when you have had [so many] profit warnings,” says Nick Cunningham, analyst at Agency Partners.

Rolls-Royce has not always had such difficulty in convincing investors that it knew best. Under Sir John Rose, chief executive for 15 years to 2011, the group went from being a bit player in the global aero-engine market to the world’s second largest.

Although there were turbulent times, such as the post 9/11 downturn, Sir John could be famously dismissive of those who did not share his long-term vision.

“Rose just pointed to the next 10 years and said the business would double in size,” says another former colleague. “He told investors that it would be a bumpy ride sometimes, but we will double in size.”

Some analysts became frustrated with what they regarded as the company’s arrogance, and many questioned the aggressive accounting policies that brought forward earnings on maintenance contracts. They could not argue with Sir John’s success, though. When he left the company four years ago, its order book stood at close to 60 billion pounds, up from 7.6 billion pounds in 1997.

Part of the difficulty in getting the long-term message across in recent years has been the loss of not only Sir John’s supreme confidence but also some other seasoned communicators.

Simon Robertson, the former Goldman Sachs banker who was chairman for eight years and Andrew Shilston, the former finance director, were able to make up for Sir John’s often peremptory handling of analysts’ questions. “I don’t think they would have got themselves into this mess,” says one long-time shareholder.

Their departure left Rolls in the hands of a team little known to the city: Ian Davis, a former head of McKinsey, became chairman; Mark Morris was promoted from treasury to finance director; and John Rishton, a non-executive director and former chief executive of Dutch retailer, Ahold, took over from Sir John.

Rishton struggled from the start to win investors’ confidence, even if the shares continued to rise on the back of a growing aerospace order book. “He didn’t come from the right background,” says one investor. “Some people never liked him. Rose was regarded as technically sound.”

But Rishton also faced a confluence of events that shook confidence in the long term.

Rolls-Royce’s dominant aerospace division had pulled in record orders, but now it would have to deliver — and its industrial base was in sore need of modernising to be efficient enough to do so on time and on budget.

At the same time, Rolls-Royce’s cash position had become more volatile. After years of investment, shareholders wanted to see returns start pouring through. Instead, Rishton opted to cement the diversification strategy launched by his predecessor.

He spent more than 1 billion pounds in 2014 to buy Daimler out of a power systems joint venture. He also took a hit when exiting a narrow body aircraft engine partnership with Pratt & Whitney, and missed out on a boom in short-haul aircraft orders.

While these decisions were blamed on Rishton, some now see them as the logical conclusion to strategic moves by Sir John much earlier: first, to counter the risks in aerospace with shorter cycle diversification; and, second, to focus on engines for the wide-body market where Rolls-Royce is set to hold 50 per cent of the installed base.

A collapse in defence orders and then in the marine engine market, as a tumbling oil price halted offshore investment, have compounded the problem.

Rolls-Royce’s profit warning in February 2014 was a watershed. Not only was it the first time Rolls-Royce had warned on profits in a decade, but it also laid bare the lack of City experience on the board. One analyst was allowed to issue a buy recommendation on the company on the eve of the warning.

Subsequent warnings — the last just a few days into East’s tenure — instilled deep anxiety over whether the management knew what was happening in its different businesses. Those concerns have opened the door for an activist such as ValueAct.

East now has to prove that he can address concerns over the transparency and profitability of Rolls-Royce’s civil aerospace business before he can win faith in the diversification strategy.

Costs have to be brought down if the group is to have the resources to compete in new engine technology with rivals General Electric and Pratt & Whitney, which enjoy higher margins.

Some work has already been done and margins will eventually benefit from an investment in state-of-the-art capacity that has been dragging on returns. But more is needed. East will have to set that out in the operational review due at the end of the year.

In the end, confidence in Rolls-Royce’s long-term future will return if the strategy makes sense to investors. That requires a defter handling of the City than in recent years.

“It is a matter of presenting appropriate evidence,” says one investor. “If you put forward a sound case, the market will usually back it. Shareholders can be very patient for a business that delivers returns, even over a long period.”

— Financial Times