© Rolls-Royce Group plc 2004
Legal information
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| As a result of our robust business model, strong and maturing
product portfolio and reducing cost base, we believe that the Group
is capable of achieving a ten per cent return on sales across all
our businesses, as measured by earnings before interest and tax
(EBIT) margin. We have started to move forward again, having stabilised the business after the events of September 11, 2001. Overall profitability improved during the year and debt levels reduced. Results for the yearUnderlying profit before tax* increased by 12 per cent to £285 million (2002 £255 million), and underlying earnings per share* were 12.20p (2002 11.10p). Basic earnings per share were 7.04p (2002 3.29p).* excluding exceptional and non-trading items, defined in note 2. Sales reduced by £143 million:
The Group reinforced its position as a global business, with 82 per cent of sales to customers outside the UK. Gross margin, before exceptional items, increased from 16.3 per cent to 17.3 per cent, despite the continuing difficult trading conditions in the civil aerospace sector. Margins benefited from continuing growth in aftermarket sales and our substantial rationalisation programme. The net interest charge reduced from £107 million to £90 million. This reflected a reduction in the level of average net debt, which was achieved through the Group’s continuing focus on cash management. Group interest was covered 4.9 times, based upon underlying profit before interest, excluding joint ventures. The Group completed the restructuring programme announced in 2001 without industrial disruption. At the end of 2003, the number of employees was 35,200, representing a net reduction of 2,100 during the year. The Group is on target to achieve annual cost savings of £270 million from this restructuring exercise. Following the completion of this major programme, future restructuring will be in the nature of ongoing operational improvements and charges in this respect will be included within operating costs. The Group made an underlying profit before tax of £285 million (2002 £255 million). After charging exceptional and non-trading items, profit before tax was £180 million (2002 £105 million). Net working capital as a percentage of sales, was 6.8 per cent (2002 6.8 per cent). An interim dividend of 3.18p was declared with the half year results in July 2003. The company will announce proposals to issue B Shares in place of dividends in order to accelerate the recovery of its advanced corporation tax. Conditional upon approval by shareholders, a final payment of 5.00p will be paid in the form of B Shares (see Report of the directors) resulting in a total payment to shareholders including B Shares of 8.18p (2002 8.18p). Included within underlying earnings were a number of charges:
Capital reorganisationDuring the yearOrder bookThe order book was £17.4 billion (2002 £16.2 billion). Items are included in the order book when a signed contract exists.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 until they become firm, signed orders. 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. Long-term service agreements, including TotalCare packages for aftermarket services, represented 27 per cent of the order book. These are long-term contracts where only the first seven years’ revenue is included in the order book. Business which has been announced but for which contracts have not yet been signed is excluded from the order book. This amounted to a further £1.3 billion at the year-end (2002 £0.9 billion). Aftermarket servicesThe Group has been successful in developing its aftermarket services activities. These accounted for 50 per cent of turnover in 2003.Particular success has been achieved in the development of TotalCare packages, which cover 45 per cent of flying hours for engines delivered during the year. TotalCare packages cover long-term support for customers’ engines, including contracts where the engine maintenance agreement is linked to, and entered into, at the same time as the original equipment sale. Sale of spare parts, support activities and, where relevant, the original equipment sale will form part of the same long-term contract. The pricing of such contracts differs from conventional engine sales and support and reflects the long-term nature of the contract. Profit is taken progressively on a prudent basis resulting in a net asset of £454 million on the balance sheet. CashSee the Group cash flow statement.Net debt for the year reduced by £272 million, to £323 million (2002 £595 million). The average net debt level reduced from £1,090 million to £950 million. The average net debt is expected to reduce further in 2004. Net cash flow from operating activities was £753 million (2002 £778 million), before £80 million which was expended on restructuring activities. Capital expenditure used £196 million of funds generated. TaxationThe overall tax charge on the profit before tax was £64 million (2002 £52 million), a rate of 35 per cent (2002 50 per cent). This is higher than the UK tax rate, primarily due to the impact of goodwill charged against profits for which no tax relief is available.The tax charge was reduced by £12 million (2002 £6 million) in respect of the expected benefit of the UK research and development tax credit that was introduced with effect from April 1, 2002. The tax charge on underlying profits was £84 million (2002 £76 million), a rate of 29 per cent (2002 30 per cent). Acquisitions and disposalsDuring the year the Group acquired VT Controls, made a number of disposals of small businesses, and reached agreement on the completion accounts for the 2002 disposal of Vickers Defence Systems (see notes 31 and 32).PensionsFor 2003, the charges for pensions costs continue to be calculated under SSAP 24 and are disclosed in note 30. Although the full implementation of FRS 17 (Post Retirement Benefits) has been deferred pending the introduction of International Financial Reporting Standards, certain disclosures are required, including the value of pension scheme assets and liabilities using the new rules specified by FRS 17 (see note 30). Under this standard a snapshot is taken of pension fund assets and liabilities at a specific point in time, thus movements in equity markets and discount rates will create volatility in their calculation. Additionally FRS 17 requires a memorandum analysis of the profit and loss charge.On this basis and after taking account of deferred taxation, there was a net shortfall of assets over liabilities for the UK Schemes of £855 million (2002 £1,117 million). Although this deficit takes into account the revised benefits relating to the The other two InvestmentsThe 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 £619 million (2002 £590 million). Net research and development was £281 million (2002 £297 million). Investment in training was £29 million (2002 £26 million). Capital expenditure, was £186 million (2002 £344 million). PartnershipsThe 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 (RRSPs).Joint venturesJoint ventures are an integral part of our business. They are involved in engineering and manufacturing, repair and overhaul, and financial services. They share risk and investment, bring expertise and access to markets, and provide external objectivity. 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. The recourse financing obligations total £39 million and are included in contingent liabilities (see note 28).Pembroke, the Group’s aircraft leasing and management joint venture is not regarded as core to the Group’s strategy and, as markets permit, the Group will be seeking to extract value from this business. Investment in the engine leasing joint venture, Risk and Revenue Sharing PartnersRRSPs 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 profit and loss account and the receipts from partners are also recorded in the profit and loss account, as other operating income.RRSP agreements are a standard form of cooperation in the civil aero-engine industry. They bring benefits to the engine manufacturer and the partner. For the manufacturer they bring some or all of the following benefits: additional financial and engineering resource; sharing of risk; and initial programme investment contribution. As appropriate, the partner supplies components free of charge and subsequently 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. All receipts from RRSPs are recorded as ‘other operating income’. In 2003 other operating income in respect of RRSP agreements amounted to £153 million (2002 £158 million). Payments to RRSPs are recorded within cost of sales and will increase as the related programme sales increase. These amounted to £179 million (2002 £139 million). Intangible assetsThe Group carried forward £863 million of intangible assets, including purchased goodwill of £759 million, engine certification costs carried forward amounted to £61 million and application engineering costs carried forward amounted to £43 million.Risk managementThe 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, in order to enable the corporate objectives to be achieved through the operation of theFinancial risk managementThe 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 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 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. The Group’s policy is to monitor and manage its exposure to counterparties. Credit limits are set to cover all financial instruments for each counterparty. The Group’s policy is that where exposure is only linked to the credit quality of the counterparty, the related long-term credit rating should be A3/A or better. Funding and liquidity riskThe 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. It employs derivatives where appropriate to generate the desired currency and interest rate profile.During 2003 the Group, through the normal course of business, refinanced £380 million of borrowing facilities in a number of currencies and a range of maturities. As at December 31, 2003 the Group had total committed borrowing facilities of £2.2 billion. The terms for the recently completed refinancings are substantially similar to the Group’s previous facilities. 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 is expected to arise from a movement in the Group’s credit rating. The Group holds financial investments and maintains undrawn committed facilities at a level sufficient to ensure the Group has available funds to meet its medium-term capital and funding obligations and to meet any unforeseen obligations and opportunities. The Group from time to time holds cash and short-term investments which, together with the undrawn committed facilities, enable the Group to manage its liquidity risk. Currency riskThe Group is exposed to movements in exchange rates for both foreign currency transactions and the translation of net assets and profit and loss accounts of foreign subsidiaries.The Group regards its interests in overseas subsidiary companies as long-term investments. Consequently, it does not normally hedge the translation effect of exchange rate movements on the profit and loss account for these businesses. The Group is exposed to a number of foreign currencies. The most significant transactional currency exposure is the US dollar followed by the Euro. US dollar income, net of expenditure represents 23 per cent of Group turnover. 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. 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 extends for periods of up to eight years and is in the form of standard foreign exchange contracts and instruments on which the exchange rates achieved may be dependent on future interest rates. The Group also writes currency options against a portion of the unhedged dollar income at a rate which is consistent with the Group’s long-term target rate. The premium received from the sale of the options is included in the Group’s achieved exchange rate. Total US dollar cover approximated to four and a half years’ net US dollar income at December 31, 2003 (2002 five years). The consequence of this policy has been to maintain a relatively stable long-term foreign exchange rate. Note 24, financial instruments, includes the impact of revaluing forward currency contracts at market values on December 31, 2003, showing an increase in value of £724 million. This figure, which for 2002 was an increase in value of £151 million, 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 riskThe Group uses fixed rate bonds and floating rate debt as funding sources. The Group’s policy is to maintain a higher proportion of net debt at fixed rates of interest having regard to the prevailing interest rate outlook. To implement this policy the Group utilises a combination of interest rate swaps, forward rate agreements and interest caps to manage the exposure.Commodity riskThe Group has an ongoing exposure to the price of jet fuel 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 a written policy set by the Board. Hedging is conducted using commodity swaps that extend for periods of up to four years.Sales financingIn 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 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 permitted levels of gross and net exposure are limited in aggregate by counterparty, by product type and by calendar year. 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 by the Chief Executive, and Finance Director. 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’s exposure management process falls into three phases:
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. Contingent liabilitiesNote 28 to the accounts describes the Group’s contingent liabilities under sales financing arrangements.The gross contingent liability reduced slightly to £1,090 million (2002 £1,093 million), of which £39 million (2002 £35 million) related to sales financing support provided to joint ventures. The gross contingent liability figure is calculated by aggregating the maximum exposure on all such sales financing commitments, before applying the value of the underlying security, but offsetting sums separately insured and sums provided for in the balance sheet. In 2003 provisions against customer financing exposures were increased by £38 million and £10 million of existing provisions were utilised. Provisions of £92 million were carried forward in respect of sales financing commitments (see note 22). The Group’s contingent liabilities are divided approximately 60:40 between asset value guarantees (AVGs) and credit guarantees. They spread over many years and relate to a number of customers and a broad product portfolio. The contingent liabilities represent the maximum 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. Exposures are not reduced to a net present value for the purposes of reporting the Group’s contingent liabilities. The Group uses Airclaims Limited as an independent appraiser to value its security portfolio at both the half-year and year-end. Airclaims 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. They incorporate Airclaims’ assessment of aircraft values. After taking account of the underlying security, the Group’s net contingent liability reduced slightly to £184 million (2002 £186 million). The year on year movement in reported contingent liabilities reflects the utilisation of sales finance commitments in the last year, the attrition of existing contingent liabilities through natural debt retirement or risk transfer, and, additionally in the case of net contingent liabilities, the changes in the level, form, and value of any underlying security. In reporting the Group’s contingent liability with respect to sales financing, the Group includes a net exposure stress test which incorporates the impact of a 20 per cent fall in the value of all securities compared to the Airclaims current and future values. Application of this stress test results in a net contingent liability of £262 million (2002 £251 million). The directors regard the possibility that there will be any significant loss arising from these contingencies as remote. AVGs require a period of notice to be given before they can be exercised. No such notice has been received that would enable AVGs to crystallise in 2004. The Group took charges and made prudent provisions against credit exposures in 2003. International Financial Reporting StandardsAll European Union listed companies are required to adopt International Financial Reporting Standards (IFRS) for their financial statements from 2005, which will include comparative information for 2004. The Group has been undertaking a detailed assessment of the impact of IFRS on its published financial statements. Although these standards are themselves evolving and undergoing improvement, the review has identified that the key areas of impact include: the mark-to-market of financial instruments; the requirement to capitalise a portion of research and development expenditure; and the accounting treatment for defined benefit pension schemes.As noted earlier, a significant element of the Group’s trading is denominated in US dollars. In order to protect itself from the associated currency volatility, the Group takes significant levels of forward cover, which approximates to four and a half years’ net US dollar income. Currently, gains or losses arising on these forward exchange contracts are taken to the profit and loss account in the same period as the underlying transaction. IAS 39 (Financial instruments) requires all hedges to be strictly designated against specific income and the hedge effectiveness tested. All such instruments are required to be revalued to market values at the balance sheet date. If the hedging criteria are not achieved, then the change in value is taken to the profit and loss account. As contracts may be signed several years in advance of delivery, the delivery dates and hence payment dates on contracts may, and frequently do, change. Thus meeting the strict hedging criteria for all contracts may not be practicable, resulting in potential volatility in the reported profit and loss account and balance sheet. In assessing the adoption of IAS 39, the Group has no plans to amend the underlying policy for the economic hedging of its exposures. The Group’s expenditure on self-funded research and development is of the order of £300 million per annum. Since privatisation in 1987, such expenditure has prudently been expensed as incurred, a policy which the Group believes conforms with industry practice. IAS 38 (Intangible assets) requires development expenditure meeting certain recognition criteria to be capitalised on the balance sheet. This standard is to be applied retrospectively; hence the intangible asset will include amounts expensed in previous years. Impairment testing will be required at each balance sheet date, which could introduce significant profit and loss account volatility. As noted earlier, RRSP receipts reduce the burden of research and development expenditure, and therefore a change to the Group’s policy in respect of research and development would also necessitate consideration of the treatment of RRSP receipts. Under IAS 19 (Employment benefits) the net position on the Group’s pension schemes based on market values will be included on the balance sheet. This is expected to be broadly in line with FRS 17 amounts disclosed in note 30. The application of these and other standards is being further investigated. Share priceDuring the yearThe Company’s shares ranged in price from 64p in March to 190p in November. The number of shares in issue at the end of the year was 1,667 million, an increase of 50 million of which one million related to share options and 49 million related to scrip dividends. The average number of shares in issue was 1,647 million (2002 1,612 million). Underlying earnings per share were 12.2p an increase of ten per cent over 2002. The proposed final payment per share will result in a total payment of 8.18p per share (see Report of the directors).  Financial servicesThe financial services businesses comprise: engine leasing (Rolls-Royce & Partners Finance), aircraft leasing (Pembroke), and electrical power project development (Rolls-Royce Power Ventures).Rolls-Royce & Partners Finance, the Group’s joint venture engine leasing business, owns a portfolio of 259 engines with 35 customers. The proportion of engines on lease remains high, at 98 per cent, by value. Pembroke, the Group’s joint venture aircraft leasing business, owns 28 aircraft on lease to 14 customers, 96 per cent, by value, of the owned aircraft fleet is on lease. A major refinancing of Boeing 737 aircraft was concluded during the year, without parent company support. The shareholders of Pembroke are discussing ways of realising value from the company as markets improve. Rolls-Royce Power Ventures, the Group’s power project developer, has 13 power generation projects in operation and four in construction or commissioning. The business is being restructured, reflecting the general weakness in power generation markets. Charges of £15 million were taken as the process of realising capital from the assets started.  Andrew Shilston Finance Director |
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