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© Rolls-Royce plc 2008 Legal Information
Finance Director's review
- +Results for the year
- +Summary
- +Order book
- +Aftermarket services
- +Cash
- +Taxation
- +Pensions
- +Strategic financial review
- +Investments
- +Intangible assets
- +Partnerships
- +Joint ventures
- +Risk and revenue sharing partners (RRSPs)
- +Risk management
- +Financial risk
- +Counterparty credit risk
- +Funding and liquidity
- +Credit rating
- +Currency risk
- +Interest rate risk
- +Commodity risk
- +Sales financing
- +Accounting standards
- +Share price
Results for the year
Underlying profit before tax increased by 13 per cent to £800 million (2006 £705 million), and underlying earnings per ordinary share were 34.06p (2006 29.81p). Basic earnings per ordinary share were 33.67p (2006 57.32p).
Summary
Underlying sales increased by six per cent.
- Engine deliveries in the civil aerospace business were broadly flat at 851 in 2007. There was a change in the mix, a reduction in the deliveries of large Trent engines was balanced by increased deliveries of smaller engines for the corporate and regional sector. As a consequence, new engine revenues reduced by seven per cent in 2007. Underlying civil aerospace services revenues grew by 11 per cent.
- Underlying defence aerospace sales increased by four per cent, with a six per cent increase in original equipment sales and a three per cent increase in services revenues.
- Underlying marine sales increased by 19 per cent, with continued strong growth in the offshore oil and gas support market sector.
- Underlying energy sales were flat, with a 15 per cent increase in services revenues, offsetting a decline in original equipment sales.
Underlying aftermarket services revenues grew by nine per cent to £4.3 billion and have grown by ten per cent per annum compound over the past ten years. Service revenues accounted for 55 per cent of total revenues.
84 per cent of sales were to customers outside the UK.
Underlying profit margins before financing costs were relatively flat with improvement in original equipment demand, continuing growth in services sales and our focus on cost reduction mitigating headwinds caused by commodity price inflation and an adverse trend in our achieved US dollar exchange rate.
Underlying financing amounted to £32 million (2006 £43 million), comprising net interest (£6 million) and risk and revenue sharing partners' finance cost (£26 million).
Restructuring charges of £52 million (2006 £47 million), which were incurred for ongoing operational improvements, were included within operating costs.
On the basis described below, underlying profit before tax was £800 million (2006 £705 million).
The published profit before tax reduced to £733 million from £1,391 million in 2006. This is primarily due to reduced benefits from the unrealised fair value derivative contracts, lower benefit from foreign exchange hedge reserve release and finally the recognition of past service costs for UK pension schemes, all of which are excluded from the calculation of underlying performance.
The Group is exposed to fluctuations in foreign currency exchange rates and commodity price movements. These exposures are mitigated through the use of currency and commodity derivatives for which the Group does not apply hedge accounting.
As a result, reported earnings do not reflect the economic substance of derivatives that have been closed out in the financial year, but do include unrealised gains and losses on derivatives which will only affect cash flows when they are closed out at some point in the future.
Underlying earnings are presented on a basis that shows the economic substance of the Group's hedging strategies in respect of transactional exchange rate and commodity price movements. Further information is included within key performance indicators.
A final payment to ordinary shareholders of 8.96p in the form of B Shares is proposed making a total of 13.00p per ordinary share (2006 9.59p), a 35 per cent increase over the total payment in 2006.
Order book
The order book at December 31, 2007, at constant exchange rates, was £45.9 billion (2006 £26.1 billion).
This included firm business that was announced but for which contracts had not yet been signed of £7.1 billion (2006 £1.7 billion).
In civil aerospace, it is common for a customer to take options for future orders in addition to firm orders placed. Such options are excluded from the order book.
In defence aerospace, long-term programmes are often ordered for only one year at a time. In such circumstances, even though there may be no alternative engine choice available to the customer, only the contracted business is included in the order book.
Aftermarket services agreements, including TotalCare packages, represented 28 per cent of the order book having increased by £3.2 billion in the year. These are long-term contracts where only the first seven years revenue is included in the order book.
Aftermarket services
The Group continues to be successful in developing its aftermarket services activities. These grew by nine per cent on an underlying basis in 2007 and accounted for 55 per cent of Group revenue.
In particular, TotalCare packages in the civil aerospace sector now cover 55 per cent, by value, of the installed fleet. TotalCare packages cover long-term management of the maintenance and associated logistics for our engines and systems, monitoring the equipment in service to deliver the system availability our customers require with predictable costs. The pricing of such contracts reflects their long-term nature. Revenues and costs are recognised based on the stage of completion of the contract, generally measured by reference to flying hours. The overall net position of assets and liabilities on the balance sheet for TotalCare packages was an asset of £550 million (2006 £393 million).
Cash
Cash inflow during the year was £562 million (2006 £491 million) before the special injection of £500 million in to the UK defined benefit pension schemes. Continued growth in underlying profits and good cash conversion was supported by further increases in customer deposits and progress payments in the year, increasing by £332 million, and a benefit of £41 million from year-end currency revaluations. Total cash investments of £598 million in plant and equipment and intangible assets and payments to shareholders of £97 million represent the major cash outflows in the period. Tax payments increased in the year to £71 million (2006 £25 million).
As a consequence average net cash was £350 million (2006 £150 million). The net cash balance at the year-end was £888 million (2006 £826 million).
Taxation
The overall tax charge on the profit before tax was £133 million (2006 £397 million) a rate of 18.1 per cent (2006 28.5 per cent).
The tax charge was reduced by £35 million in respect of the adjustment of deferred tax balances to reflect future lower corporate tax rates in the UK and Germany and £22 million in respect of the expected benefit of the UK research and development tax credit. In addition, £22 million of provisions for prior years' tax liabilities were written back following settlement of a number of outstanding tax issues.
The tax charge on underlying profit was £193 million (2006 £190 million) a rate of 24.1 per cent (2006 27.0 per cent). The reduction mainly reflects prior years' tax provisions no longer required as noted above.
The operation of most tax systems, including the availability of specific tax deductions, means that there is often a delay between the Group tax charge and the related tax payments, to the benefit of cash flow.
The Group operates internationally and is subject to tax in many differing jurisdictions. As a consequence, the Group is routinely subject to tax audits and examinations which by their nature can take a considerable period to conclude. Provision is made for known issues based on management's interpretation of country specific legislation and the likely outcome.
The Group seeks to minimise its tax burden in a manner which is consistent with its commercial objectives and meets its legal obligations and ethical standards. While every effort is made to maximise the tax efficiency of its business transactions, the Group does not use artificial structures in its tax planning. The Group has regard for the intention of the legislation concerned rather than just the wording itself. The Group is committed to building open relationships with tax authorities and to follow a policy of full disclosure in order to effect the timely settlement of its tax affairs and to remove uncertainty in its business transactions.
Pensions
As for 2006, the charges for pensions are calculated in accordance with the requirements of IAS 19 Employee Benefits.
As the Group had previously announced, during 2007 the trustees of each of the UK defined benefit schemes undertook a review of their investment strategies, in consultation with the Group. As a result, revised investment strategies have been adopted that seek to reduce the economic risks arising from each scheme. The impact on the asset allocation of each scheme from the implementation of the revised investment strategies has been to reduce the equity allocation and increase the fixed income allocation. Each scheme has appointed a liability-driven investment asset manager to hedge the majority of the interest rate and inflation risks associated with the pension liabilities, using swap contracts backed by short-term money market assets. Under the terms of the swap contracts, each scheme is committed to paying London Inter-Bank Offered Rate (LIBOR) to its counterparties in exchange for fixed or inflation-linked cash inflows to match in large part an actuarial projection of future benefit payments to scheme members.
Following agreement of the revised investment strategies with the trustees of each scheme, the Group has paid additional contributions of £500 million to the principal UK pension schemes.
Further information and details of the pensions' charge and the defined benefit schemes' assets and liabilities are shown in note 18 to the financial statements. This shows a net deficit, after taking account of deferred tax, of £88 million (2006 £681 million). Changes in this net position are affected by the assumptions made in valuing the liabilities and the market performance of the assets.
The change in investment strategies agreed with the trustees of the principal UK schemes is expected to lead to lower volatility of the Group's net pension position for the future.
Strategic financial review
Following the successful completion of the UK defined benefit pension scheme restructuring, a review of the Group's financial strategy with reference to the manner and quantity of shareholder remuneration, and the structure of the balance sheet has been conducted.
The Group has developed a robust financial position over the previous four years as strong market positions, increasing market share and a continued growth in aftermarket revenues have driven growth in profitability and cash generation. The review was conducted in the context that the business model will continue to strengthen as our portfolio broadens further and the aftermarket business opportunity expands, all delivering increasingly resilient and predictable financial performance.
The length of the investment cycles within which our products and services operate, and the long-term relationships that we maintain with our customers and suppliers all mean that it is crucial to build and retain a strong balance sheet on which to continue to compete in the future. The Group benefits from many opportunities to deliver long-term growth by continuing to invest in products, technology, and improved routes to market. These activities require both financial strength and continued investment in the business, not always at a time of the Group's choosing.
In 2007, external events have been less positive, with the dollar weakening significantly against all major currencies and with a major crisis in the global banking industry. Confidence amongst consumers and in businesses has been eroded and the significant volatility seen in global markets at the start of 2008 reinforces the Board's opinion that financial flexibility is at a premium.
The review has concluded that the overall strength of the business and its future prospects justify a significant increase in the payment to shareholders. The Board is therefore proposing that payments to shareholders for 2007 will, in aggregate, be 35 per cent higher than 2006. Subsequent payments are expected to increase progressively in the light of the Group's future performance.
The Board will be seeking shareholder agreement at the 2008 AGM to amend the method used to make payments to shareholders, this is described further in the Report of the directors.
Investments
The Group continues to subject all investments to rigorous examination of risks and future cash flows to ensure that they create shareholder value. All major investments require Board approval.
The Group has a portfolio of projects at different stages of their life cycles. Discounted cash flow analysis of the remaining life of projects is performed on a regular basis. Sales of engines in production are assessed against criteria in the original development programme to ensure that overall value is enhanced.
Gross research and development investment amounted to £824 million (2006 £747 million). Net research and development charged to the income statement was £381 million (2006 £370 million).The level of self-funded investment in research and development is expected to remain at approximately five per cent of Group sales in the future. The impact of this investment on the income statement will reflect the mix and maturity of individual development programmes and will result in a similar level of net research and development reported within the income statement in 2008. Investment in training was £30 million (2006 £30 million).
Capital expenditure on property, plant and equipment was £304 million (2006 £303 million).
Intangible assets
The Group carried forward £1,761 million (2006 £1,460 million) of intangible assets. This comprised purchased goodwill of £801 million, engine certification costs and participation fees of £354 million, development costs of £364 million, recoverable engine costs of £162 million and other intangible assets of £80 million.
Total capital expenditure on property, plant and equipment and intangible assets is expected to increase modestly in 2008.
Partnerships
The development of effective partnerships continues to be a key feature of the Group's long-term strategy. Major partnerships are of two types: joint ventures and risk and revenue sharing partners.
Joint ventures
Joint ventures are an integral part of our business. They are involved in engineering, manufacturing, repair and overhaul, and financial services. They are also normal business structures for companies participating in international, collaborative defence projects.
They share risk and investment, bring expertise and access to markets, and provide external objectivity. Some of our joint ventures have become substantial businesses. A major proportion of the debt of the joint ventures is secured on the assets of the respective companies and is non-recourse to the Group.
Risk and revenue sharing partners (RRSPs)
RRSPs have enabled the Group to build a broad portfolio of engines, thereby reducing the exposure of the business to individual product risk. The primary financial benefit is a reduction of the burden of research and development (R&D) expenditure on new programmes.
The related R&D expenditure is expensed through the income statement and the initial programme receipts from partners, which reimburse the Group for past R&D expenditure, are also recorded in the income statement, as other operating income.
RRSP agreements are a standard form of co-operation in the civil aero-engine industry. They bring benefits to the engine manufacturer and the partner. Specifically, for the manufacturer they bring some or all of the following benefits: additional financial and engineering resource; sharing of risk; and initial programme contribution. As appropriate, the partner also supplies components and as consideration for these components, receives a share of the long-term revenues generated by the engine programme in proportion to its purchased programme share.
The sharing of risk is fundamental to RRSP agreements. In general, partners share financial investment in the programme; they share market risk as they receive their return from future sales; they share currency risk as their returns are denominated in US dollars; they share sales financing obligations; they share warranty costs; and, where they are manufacturing or development partners, they share technical and cost risk. Partners that do not undertake development work or supply components are referred to as financial RRSPs and are accounted for as financial instruments as described here.
In 2007, the Group received other operating income of £50 million (2006 £57 million), primarily in respect of the Trent 1000 engine programme.
Payments to RRSPs are recorded within cost of sales and increase as the related programme sales increase. These payments amounted to £199 million (2006 £162 million).
The classification of financial RRSPs as financial instruments has resulted in a liability of £315 million (2006 £324 million) being recorded in the balance sheet and an associated underlying financing cost of £26 million (2006 £27 million) recorded in the income statement.
In the past, the Group has also received government launch investment in respect of certain programmes. The treatment of this investment is similar to non-financial RRSPs.
Risk management
The Board has an established, structured approach to risk management. The risk committee (see Report of the directors) has accountability for the system of risk management and reporting the key risks and associated mitigating actions. The Director of Risk reports to the Finance Director. The Group's policy is to preserve the resources upon which its continuing reputation, viability and profitability are built, to enable the corporate objectives to be achieved through the operation of the Rolls-Royce business processes. Risks are formally identified and recorded in a corporate risk register and its subsidiary registers within the businesses, which are reviewed and updated on a regular basis, with risk mitigation plans identified for significant risks.
Financial risk
The Group uses various financial instruments in order to manage the exposures that arise from its business operations as a result of movements in financial markets. All treasury activities are focused on the management and hedging of risk. It is the Group's policy not to trade financial instruments or to engage in speculative financial transactions. There have been no significant changes in the Group's policies in the last year.
The principal economic and market risks continue to be movements in foreign currency exchange rates, interest rates and commodity prices. The Board regularly reviews the Group's exposures and financial risk management and a specialist committee also considers these in detail.
All such exposures are managed by the Group Treasury function, which reports to the Finance Director and which operates within written policies approved by the Board and within the internal control framework described in the Report of the directors.
Counterparty credit risk
The Group has an established policy towards managing counterparty credit risk. A common framework exists to measure, report and control exposures to counterparties across the Group using Value at Risk and fair value techniques. The Group assigns an internal credit rating to each counterparty, which is assessed with reference to publicly available credit information, such as that provided by Moody's, Standard & Poor's, and other recognised market sources and is reviewed regularly.
Financial instruments are only transacted with counterparties that have a publicly assigned long-term credit rating from Standard & Poor's of 'A-' or better and from Moody's of 'A3' or better.
Funding and liquidity
The Group finances its operations through a mixture of shareholders' funds, bank borrowings, bonds, notes and finance leases. The Group borrows in the major global markets in a range of currencies and employs derivatives where appropriate to generate the desired currency and interest rate profile.
The Group's objective is to hold financial investments and maintain undrawn committed facilities at a level sufficient to ensure that the Group has available funds to meet its medium-term capital and funding obligations and to meet any unforeseen obligations and opportunities. The Group holds cash and short-term investments which, together with the undrawn committed facilities, enable the Group to manage its liquidity risk.
Short-term investments are generally held as bank deposits or in 'AAA' rated money market funds. The Group operates a conservative investment policy which limits investments to high quality instruments with suitable counterparty diversification. During 2007, the Group did not experience any losses related to its investments as a result of the US sub-prime crisis.
No new borrowing facilities were entered into during 2007 and £340 million of borrowing facilities matured during 2007. As at December 31, 2007 the Group had total committed borrowing facilities of £1.5 billion (2006 £1.8 billion). There are no material debt facility maturities until 2011. The maturity profile of the borrowing facilities is staggered to ensure that refinancing levels are manageable in the context of the business and market conditions.
There are no rating triggers contained in any of the Group's facilities that could require the Group to accelerate or repay any facility for a given movement in the Group's credit rating, and no material impact on the Group's interest charge would be expected to arise from a movement in the Group's credit rating.
The Group continues to have access to all the major global debt markets.
Credit rating
The Group subscribes to both Moody's Investors Service and Standard & Poor's for its official publicised credit ratings. As at December 31, 2007 the Group's assigned long-term credit ratings were:
| Rating agency | Rating | Outlook | Category |
|---|---|---|---|
| Moody's | A3 | Stable | Investment grade |
| Standard & Poor's | A- | Stable | Investment grade |
As a long-term business, the Group attaches significant importance to maintaining an investment grade credit rating, which it views as necessary for the business to operate effectively.
The Group's objective is to maintain an 'A' category investment grade credit rating from both agencies.
Currency risk
The Group is exposed to movements in exchange rates for both foreign currency transactions and the translation of net assets and income statements of foreign subsidiaries.
The Group regards its interests in overseas subsidiary companies as long-term investments. The Group has tended to manage its translational exposures through the currency matching of assets and liabilities where applicable. The matching is reviewed regularly. Appropriate risk mitigation is undertaken where material mismatches arise.
The Group is exposed to a number of foreign currencies. The most significant transactional currency exposures are US dollars to sterling and US dollars to Euros.
The Group manages its exposure to movements in exchange rates at two levels:
- Revenues and costs are currency matched where it is economic to do so. The Group actively seeks to source suppliers with the relevant currency cost base to avoid the risk or to flow down the risk to those suppliers that are capable of managing it. Currency risk is also a prime consideration when deciding where to locate new facilities. US dollar income converted into Sterling represented 25 per cent of Group revenues in 2007 (2006 26 per cent). US dollar income converted into Euros represented four per cent of Group revenues in 2007 (2006 four per cent).
- Residual currency exposure is hedged via the financial markets. The Group operates a hedging policy using a variety of financial instruments with the objective of minimising the impact of fluctuations in exchange rates on future transactions and cash flows.
| 2007 | 2006 | |
|---|---|---|
| US$ per £ | ||
| - Year-end spot rate | 1.991 | 1.957 |
| - Average spot rate | 2.001 | 1.844 |
| € per £ | ||
| - Year-end spot rate | 1.362 | 1.484 |
| - Average spot rate | 1.461 | 1.467 |
The permitted range of the amount of cover taken is determined by the written policies set by the Board, based on known and forecast income levels.
The forward cover is managed within the parameters of these policies in order to achieve the Group's objectives, having regard to the Group's view of long-term exchange rates. Forward cover is in the form of standard foreign exchange contracts and instruments on which the exchange rates achieved are dependent on future interest rates. The Group may also write currency options against a portion of the unhedged dollar income at a rate which is consistent with the Group's long-term target rate. At the end of 2007 the Group had US$9.4 billion of forward cover (2006 US$10 billion).
The consequence of this policy has been to maintain relatively stable long-term foreign exchange rates. Note 16 includes the impact of revaluing forward currency contracts at market values on December 31, 2007, showing a value of £379 million (2006 £554 million) which will fluctuate with exchange rates over time. The Group has entered into these forward contracts as part of the hedging policy, described above, in order to mitigate the impact of volatile exchange rates.
Interest rate risk
The Group uses fixed rate bonds and floating rate debt as funding sources. The Group's policy is to maintain a proportion of its debt at fixed rates of interest having regard to the prevailing interest rate outlook. To implement this policy the Group may utilise a combination of interest-rate swaps, forward-rate agreements and interest-rate caps to manage the exposure.
Commodity risk
The Group has an ongoing exposure to the price of jet fuel and base metals arising from business operations. The Group's objective is to minimise the impact of price fluctuations. The exposure is hedged in accordance with parameters contained in written policies set by the Board.
Sales financing
In connection with the sale of its products, the Group will, on some occasions, provide financing support for its customers. This may involve the Group guaranteeing financing for customers, providing asset-value guarantees (AVGs) on aircraft for a proportion of their expected future value, or entering into leasing transactions.
The Group manages and monitors its sales finance related exposures to customers and products within written policies approved by the Board and within the internal framework described in the Report of the directors. The contingent liabilities represent the maximum discounted aggregate gross and net exposure that the Group has in respect of delivered aircraft, regardless of the point in time at which such exposures may arise.
The Group uses Ascend Worldwide Limited as an independent appraiser to value its security portfolio at both the half-year and year-end. Ascend provides specific values (both current and forecast future values) for each asset in the security portfolio. These values are then used to assess the Group's net exposure.
The permitted levels of gross and net exposure are limited in aggregate, by counterparty, by product type and by calendar year. The Group's gross exposures are divided approximately 55:45 between AVGs and credit guarantees. They are spread over many years and relate to a number of customers and a broad product portfolio.
The Board regularly reviews the Group's sales finance related exposures and risk management activities. Each financing commitment is subject to a credit and asset review process and prior approval in accordance with Board delegations of authority.
The Group operates a sophisticated risk-pricing model to assess risk and exposure.
Costs and exposures associated with providing financing support are incorporated in any decision to secure new business.
The Group seeks to minimise the level of exposure from sales finance commitments by:
- the use of third-party non-recourse debt where appropriate;
- the transfer, sale, or reinsurance of risks; and
- ensuring the proportionate flow down of risk and exposure to relevant RRSPs.
Each of the above forms an active part of the Group's exposure management process.
Where exposures arise, the strategy has been, and continues to be, to assume where possible liquid forms of financing commitment that may be sold or transferred to third parties when the opportunity arises.
Note 23 to the financial statements describes the Group's contingent liabilities.
There were no material changes to the Group's gross and net contingent liabilities in this respect in 2007.
Accounting standards
The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU. In 2007, the Group has adopted IFRS 7 Financial Instruments: Disclosure and the Amendment to IAS 1 Presentation of Financial Statements. These changes both relate to disclosure and have no impact on the reported results. Other new standards, amendments to standards and interpretations effective in 2007 do not have a significant effect on the Group's financial statements.
A summary of other changes, which have not been adopted in 2007, is included within the accounting policies in note 1 to the financial statements.
Share price
During the year the Company's share price increased by 22 per cent from 448p to 546p per share, compared to a 20 per cent increase for the aerospace and defence sector and a four per cent increase for the FTSE 100. The Company's shares ranged in price from 444p in January to 570p in July.
The number of ordinary shares in issue at the end of the year was 1,820 million, an increase of 39 million of which 24 million related to share options and 15 million related to conversion of B Shares into ordinary shares.
The average number of ordinary shares in issue was 1,800 million (2006 1,741 million).
Andrew Shilston
Finance Director
February 6, 2008
