Rolls-Royce chief ready to begin fightback with a pitch to the City

Boxing Gloves

Warren East, the chief executive of Rolls-Royce, will herald a new era for the engineering company this week as he presents his plans for its future.

Over 10 years, East transformed the microchip maker ARM Holdings into a vital supplier to Apple and arguably Britain’s most successful technology firm. But revitalising Rolls-Royce is now the biggest challenge of his career.

The maker of jet engines and parts for nuclear reactors enjoyed 20 years of unprecedented success under Sir Ralph Robins and Sir John Rose. It established itself as one of the premier engine makers in the world, alongside fierce rivals General Electric and Pratt & Whitney. However, Rolls has found life far more difficult since Rose retired in 2011, and when East speaks on Tuesday, he will do so with the engine maker in crisis.

Not only has Rolls issued five profit warnings in the past 18 months and seen its share price fall by almost 40% in 2015, the firm is still under the shadow of a Serious Fraud Office investigation into bribery allegations in China, Indonesia and other parts of the world.

The pressure on Rolls has been cranked up by the activist investor ValueAct building up a 10% stake in the business and demanding change.

ValueAct wants Rolls to sell off its marine business, which makes engines and nuclear reactors for ships, submarines and the offshore oil and gas industry, to focus on making engines for passenger jets built by Boeing and Airbus. The investor is also pressing for a seat on the board of directors.

When ValueAct revealed it had bought a stake in Rolls in August, East wrote a letter to staff describing the investor as “opportunist”.

However, the company’s tone has notably softened since then. East and ValueAct have spoken, while the California-based investor has also held talks with other major shareholders, who have been impressed by its ideas and knowledge about Rolls. Insiders now believe it is inevitable that a ValueAct representative will eventually make their way on to the Rolls board.

The Rolls boss had already made it plain before ValueAct became involved that the company needs to change, warning earlier this month that costs were simply too high.

However, it is understood that Tuesday’s presentation will revolve around providing analysts and investors with more information about Rolls, rather than bold proclamations about breaking the business up and cutting jobs.

East is likely to save announcements regarding asset sales and job losses for the full-year results in February.

It is thought that East will not put any businesses up for sale or place a number on how many posts will go among Rolls’ 54,000 global workforce.

However, in a clear indication that it could eventually sell off businesses and move away from a strategy of diversifying across sectors, East will pick out where the company is doing well and where it is weaker. The marine business, which is expected to lose money next year, is not likely to be identified as a strength.

This analysis will not be a broad sweep of each division, but an in-depth look at everything Rolls does. East will provide the City with reams of information about how the company makes money, including a breakdown of its vital aftermarket agreements with commercial airlines.

These lucrative deals involve the servicing of engines already in use and mean Rolls benefits financially from its engines even after they have been sold.

The public analysis might not seem revolutionary, but it will be for Rolls. Even under Rose, analysts and shareholders castigated the company for the lack of transparency about its finances, particularly those aftermarket deals with airlines. Rolls has had terrible relations with the City for years, with Rose effectively turning his nose up at those in London who had little understanding for the extraordinary work his staff were doing at its factory in Derby.

This lack of communication was accepted when Rolls was flying high, but when John Rishton replaced Rose and performance took a nosedive, enough was enough.

The company hopes Tuesday’s insights will allow analysts to better understand Rolls and make more accurate predictions about its financial performance, avoiding the need for the string of profit warnings it has put out in recent months.

No matter what East says this week or in February, it is difficult for one man to change the course of the supertanker that is Rolls, which despite its problems, still has an order book worth £76.5bn.

Decisions made now may not have an effect for years. For example, one of the company’s biggest problems is that it is not benefiting from the boom in single-aisled, narrow-bodied commercial aircraft, having decided in 2013 to focus on larger planes, such as the A380 superjumbo. That decision backfired, because demand for the A380 is disappointing, as airlines focus on building their fleets with smaller, more fuel-efficient planes.

In addition, the SFO investigation still hangs over Rolls. This could have serious ramifications – not least a big fine – and Rolls has brought in the leading law firm Slaughter & May to advise it.

But analysts believe Rolls can fight back, and it at least has the right person in charge in East.

Howard Wheeldon, an aerospace analyst who has followed the company for years, said: “The main problem is that while they have invested huge amounts of money to improve efficiency and make themselves more competitive, they have failed to make a significant enough dent in fixed costs.

“That sadly means that when revenue slips a touch, profits take a dive. Added to this is the serious oil price-related impact on marine and that while new plants are brought on stream, there is some duplication until older, less-efficient plants can be closed.

“East recognises the problems and also what needs to be done – significantly reducing the fixed cost base. He also recognises that you can’t do all that is needed in one year. I am very confident that not only have they now got the right man for the job, but that given the space, he will succeed.”

Active investment?

“Nobody does what we do,” Jeff Ubben, founder and chief executive of San Francisco-based hedge fund ValueAct Capital told his alumni magazine – at the Kellogg School of Management at Northwestern University.

“There are very few people in the market who want to get all the information about an underperformer and make a fully informed decision on behalf of all shareholders. It’s easier to sit behind a screen and generate reasonable returns without getting on a plane all the time to meet with directors.”

Ubben, who this week called for a seat on the board of Rolls-Royce after ValueAct increased its stake in the aircraft engine maker to 10%, says he tries to work with companies’ management when the fund takes a stake rather than forcing changes like other well-known activist investors such Dan Loeb, Paul Singer or Bill Ackman.

“When we go on a board, it means we’re basically locking ourselves up, we’re getting married. We see a five-year opportunity to grow our capital 20%, and we think we can be partners with management,” he told CNBC in a rare public interview in 2012.

Ubben, who manages more than $19bn of behalf of founders and investors, says he invests for the long-term.

The fund typically holds core investments in only 10-18 companies, and likes to be the biggest single shareholder to show that it is taking a significant risk on whether it can benefit from the longer term success of the company.

“We don’t come in guns blazing. We basically are rooting for the chief executive,” Ubben said. “But if he’s missing budgets for three or four quarters then we might lead a discussion more aggressively than otherwise would have occurred.”

Ubben says the fund’s less dramatic approach has led to a representative of the firm gaining a seat on half its core investments over the years. Other shareholders, he says, like ValueAct’s in-depth approach and it can lead to better performance from bosses. “There’s a little bit of, ‘Oh my God, I’m a little more accountable as a CEO to my board because I’ve got somebody in the room that has a lot of money invested and has a different sense of urgency’.”

In September, 21st Century Fox nominated Ubben to its board to reflect ValueAct’s 5.9% stake, which it began to build up after the spin-off News Corp’s newspaper business last year.

Ubben is a fan of James Murdoch, who took over as Fox CEO this summer. He described Murdoch’s “facility for technology that we have not witnessed among other industry leaders”.

The Murdochs repaid the compliment by inviting Ubben to meet India’s prime minister Narendra Modi alongside some of the biggest players in US media industry in New York in September.

However, while Ubben says he generally tries to work with chief executives, ValueAct was seen as a big player in forcing Steve Ballmer out of the door as Microsoft’s CEO in 2013.

Rupert Neate in New York

Powered by Guardian.co.ukThis article was written by Graham Ruddick, for The Guardian on Sunday 22nd November 2015 16.44 Europe/London

guardian.co.uk © Guardian News and Media Limited 2010

 

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