We have continued to improve our financial performance whilst increasing our levels of investment in the business.
Underlying profit before tax increased by 19 per cent to £705 million (2005 £593 million), and underlying earnings per ordinary share were 29.81p (2005 24.48p). Basic earnings per ordinary share were 57.32p (2005 20.11p).
Underlying sales increased by 14 per cent.
Underlying Group aftermarket services revenues grew by 13 per cent to £3.9 billion and have grown by ten per cent per annum compound over the past ten years. Service revenues accounted for 53 per cent of total revenues.
Eighty-seven per cent of sales were to customers outside the UK.
Underlying profit margins before financing costs were relatively flat with some improvement in 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 costs amounted to £43 million (2005 £86 million), comprising principally net interest (£18 million) and risk and revenue sharing partners' finance cost (£27 million). As reported with the interim results we are now excluding net post-retirement finance costs from the underlying financing costs, as they are not related to the operational performance of the Group.
Restructuring charges of £47 million (2005 £48 million), which were incurred for ongoing operational improvements, were included within operating costs.
Profit before tax was £1,391 million (2005 £477 million). On the basis described below, underlying profit before tax was £705million (2005 £593 million). The adjustments are detailed on the Segmental analysis page.
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. In particular, (a) revenues and costs denominated in US dollars and Euros are presented on the basis of the exchange rates achieved in the year, (b) similar adjustments are made in respect of commodity derivatives, and (c) consequential adjustments aremade to reflect the impact of exchange rates on monetary assets and liabilities and long-term contracts on a consistent basis.
A final payment to ordinary shareholders of 5.92p is proposed making a total of 9.59p per ordinary share (2005 8.72p), a ten per cent increase over the payment in 2005. The Company will continue to issue B Shares in place of dividends in order to accelerate the recovery of its advance corporation tax.
The order book at December 31, 2006 at constant exchange rates, was £26.1 billion (2005 £24.4 billion). This included firm business that was announced but for which contracts had not yet been signed of £1.7 billion (2005 £1.5 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 38 per cent of the order book. These are long-term contracts where only the first seven years' revenue is included in the order book.
The Group continues to be successful in developing its aftermarket services activities. These grew by 13 per cent on an underlying basis in 2006 and accounted for 53 per cent of Group revenue.
In particular, TotalCare® packages in the civil aerospace sector now cover 48 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 £393million (2005 £367 million).
Rising volumes and good management of costs resulted in the Group averaging a net cash surplus throughout the year. The Group cash flow statement is shown in the financial statements. The Group generated a positive cash flow of £491 million during 2006 (2005 £552 million). The net cash balance at the year-end was £826 million (2005 £335 million). The average net debt level position improved from £260 million to an average cash surplus of £150 million. Net cash flow from operating activities was £1,072 million (2005 £1,060 million). Positive cash flow is expected again in 2007, before any additional cash injection into the pension funds.
The overall tax charge on the profit before tax was £397 million (2005 £130 million) a rate of 28.5 per cent (2005 27.3 per cent).
The tax charge was reduced by £19 million (2005 £18 million) in respect of the expected benefit of the UK research and development tax credit.
The tax charge on underlying profit was £190 million (2005 £170 million) a rate of 27.0 per cent (2005 28.6 per cent).
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 look to 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.
As for 2005, the charges for pensions are calculated in accordance with the requirements of IAS 19 Employee Benefits.
Details of the pensions' charge and the defined benefit schemes' assets and liabilities are shown in note 23 to the financial statements. This shows a net deficit, after taking account of deferred tax, of £681 million (2005 £1,154 million). Changes in this deficit are affected by the assumptions made in valuing the liabilities and the market performance of the assets. Most importantly, the discount rate used for measuring the UK defined benefit liabilities has increased from 4.7 per cent in 2005 to 5.1 per cent in 2006. In addition, the mortality assumptions have been updated for the Rolls-Royce Pension Fund (the largest scheme in the Group) based on the actual mortality experience within the scheme and also to allow for future mortality improvements. Together with the better than expected returns on the scheme assets, overall, these factors have resulted in a reduction of the net deficit.
During 2006, a revised benefit structure was agreed with the members of the Vickers Group Pension Scheme similar to that already agreed for the Rolls-Royce Group Pension Scheme and the Rolls-Royce Pension Fund.
The formal report of the actuarial review as at March 31, 2006 in respect of the Rolls-Royce Pension Fund will be available by June 30, 2007.
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 £747 million (2005 £663 million). Net research and development was £370 million (2005 £282 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 2007. Investment in training was £30 million (2005 £30 million).
Capital expenditure on property, plant and equipment was £303 million (2005 £232 million).
The Group carried forward £1,460 million (2005 £1,315 million, restated) of intangible assets. This comprised purchased goodwill of £735 million, engine certification costs and participation fees of £231 million, development costs of £290 million, recoverable engine costs of £153 million and other intangible assets of £51 million. Total capital expenditure on property, plant and equipment and intangible assets is expected to increase modestly in 2007.
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 are an integral part of our business. They are involved in engineering and 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.
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 2006, the Group received other operating income of £57 million (2005 £60 million), primarily in respect of the Trent 1000 engine programme. Other operating income is expected to remain at a similar level in 2007.
Payments to RRSPs are recorded within cost of sales and increase as the related programme sales increase. These payments amounted to £162 million (2005 £146 million).
The classification of financial RRSPs as financial instruments has resulted in a liability of £324 million (2005 £423 million) being recorded in the balance sheet and an associated underlying financing cost of £27 million (2005 £43 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.
Following the disposal of the Group's interest in Pembroke Group, an aircraft leasing joint venture, the decision was announced to cease reporting financial services as a separate activity. Engine leasing activities are now recorded within civil aerospace and power ventures are recorded within energy. Restated comparatives are shown in note 2.
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 all significant risks.
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.
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. Counterparties are assigned a credit limit that reflects their credit standing. 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.
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.
It employs derivatives where appropriate to generate the desired currency and interest rate profile.
£62 million of borrowing facilities matured during 2006. This was replaced by a new £200 million borrowing facility relating to research and development established with the European Investment Bank (EIB). As at December 31, 2006 the Group had total committed borrowing facilities of £1.8 billion (2005 £1.7 billion).
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 holds cash and short-term investments which, together with the undrawn committed facilities, enable the Group to manage its liquidity risk.
The Group continues to have access to all the major global debt markets.
The Group subscribes to both Moody's Investors Service and Standard & Poor's for its official publicised credit ratings. As at December 31, 2006 the Group's assigned long-term credit ratings were:
|Standard & Poor's||A-||Stable||Investment grade|
The Group saw positive rating actions from both rating agencies during the year reflecting the improved business and financial profile of the Group. Standard & Poor's upgraded the Group's rating from 'BBB+' to 'A-' in June 2006 and Moody's upgraded its rating for the Group from 'Baa1' to 'A3' in November 2006.
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.
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 exposure is the US dollar followed by the Euro.
The Group manages its exposure to movements in exchange rates at two levels:
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 2006 the Group had approximately US$10 billion of forward cover (2005 US$11 billion).
The consequence of this policy has been to maintain relatively stable long-term foreign exchange rates. Note 20 includes the impact of revaluing forward currency contracts at market values on December 31, 2006, showing a value of £554 million (2005 £228 million) which will fluctuate with exchange rates over time. The Group has entered into these forward contracts as part of the hedging policy, described above, in order to mitigate the impact of volatile exchange rates.
|Market exchange rates|
|US$ per £||– Year-end spot rate||1.957||1.717|
|– Average spot rate||1.844||1.820|
|€ per £||– Year-end spot rate||1.484||1.455|
|– Average spot rate||1.467||1.463|
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.
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 a written policy set by the Board.
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 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.
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 60:40 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:
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 30 to the accounts describes the Group's contingent liabilities.
There were no material changes to the Group's gross and net contingent liabilities in this respect in 2006.
The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU. In 2006, the Group has adopted the amendments to IAS 39 Financial Instruments and IFRS 4 Financial Guarantee Contracts, resulting in sales financing commitments being classified as insurance contracts. This change has no impact on the reported results. Other new standards, amendments to standards and interpretations effective in 2006 do not have a significant effect on the Group's financial statements.
A summary of other changes, which have not been adopted in 2006, is included within the accounting policies in note 1 to the financial statements.
During the year the Rolls-Royce share price increased by five per cent from 427.5p to 447.75p per share, compared to a seven per cent increase for the aerospace and defence sector and an 11 per cent increase for the FTSE 100. The Company's shares ranged in price from 379.5p in June to 490p in April.
The number of ordinary shares in issue at the end of the year was 1,781 million, an increase of 22 million of which 8 million related to share options and 14 million related to conversion of B Shares into ordinary shares.
The average number of ordinary shares in issue was 1,741 million (2005 1,740 million).