Finance Director's review

Whilst continuing to influence the Group’s published results in 2010, currency movements were less distortive than in prior years given that average and spot rates for the GBP/USD and GBP/EUR remained in a relatively narrow range throughout the year, as shown in the table below.

Market exchange rates	2009	2010
USD per GBP
– Year end spot rate	1.615	1.566
– Average spot rate	1.566	1.543
EUR per GBP
– Year end spot rate	1.126	1.167
– Average spot rate	1.123	1.167

These movements have influenced both the reported income statement and the cash flow and closing net cash position (as set out in the cash flow statement and note 2 in the financial statements) in the following ways:

Income statement

The most important impact was the end of year mark to market of outstanding financial instruments (foreign exchange contracts; interest rate, commodity and jet fuel swaps). The principal adjustments related to the GBP/USD hedge book.

The impact of this mark to market is included in net financing in the income statement and caused a net £432 million loss, contributing to a published profit before tax of £702 million. These adjustments are non-cash, accounting adjustments required under IAS 39 Financial Instruments: Recognition and Measurement. As a result, reported earnings do not reflect the economic substance of derivatives that have been settled in the financial year, but do include the unrealised gains and losses on derivatives that will only affect cash flows when they are settled at some point in the future to match trading cash flows.

Underlying earnings are presented on a basis that shows the economic substance of the Group’s hedging strategies in respect of transactional exchange rates and commodity price movements. Further details and information are included within the section on key performance indicators and in notes 2 and 5 of the financial statements.

Underlying profit before tax of £955 million benefited from £74 million of foreign exchange benefits compared to 2009. The achieved rate on selling USD income was around nine cents better in 2010 than 2009 and is expected to improve by a similar level in 2011. In 2010, these better achieved rates contributed £72 million of transactional benefits. In addition, the improvement in the average GBP/USD of three cents contributed net translation benefits totalling £2 million to underlying profit before tax in the year.

Cash flow and balance sheet

The Group maintains a number of currency cash balances which vary throughout the financial year. These net cash balances were improved by the effects of retranslation, causing an improvement of £17 million in the 2010 cash flow and hence the closing balance sheet net cash position.

The Group’s revenues increased by six per cent in 2010 to £11,085 million with 86 per cent of revenues from customers outside the UK. Underlying revenues grew seven per cent in 2010, consisting of a three per cent improvement in original equipment revenues with services growing 13 per cent including double digit services growth in civil aerospace, marine and energy and a five per cent improvement in defence aerospace. Services activities represented 51 per cent of underlying Group underlying revenues in 2010.

• Underlying revenues in the civil aerospace segment grew ten per cent to £4,919 million (2009 £4,481 million) with a 15 per cent improvement in service revenues and a two per cent improvement in revenues from original equipment. New engine deliveries were stable at 846 (2009 844 engines) and included a record 371 V2500 engines for the Airbus A320 family of aircraft, and a small recovery in engine deliveries for corporate and regional applications. Trent deliveries for widebody commercial aircraft totalled 185 engines including a record number, 139 of Trent 700s, for the Airbus A330 aircraft. The overall total was held back by delayed entry into service and slower production ramp up in major new application, the Boeing 787 and Airbus A380 respectively. Services revenues grew strongly reflecting three key elements: the completion of a spares distribution and logistics arrangement with Aviall Inc., and the disposal of associated spares inventory which contributed around one third of the annual services growth; the effect of better GBP/USD achieved foreign exchange rates which represented around one third of the service improvement; and the ongoing utilisation and some limited recovery in discretionary service activity.
• Underlying defence aerospace revenues grew by six per cent to £2,123 million (2009 £2,010 million) supported by strong growth in deliveries for the military transport sector. Original equipment revenues grew six per cent and services revenues increased by five per cent over 2009. The portfolio proved to be resilient despite some modest effects from the completion of the Strategic Defence and Security Review (SDSR) in the UK and is expected to grow revenues at a similar overall rate in 2011.
• Underlying revenues in the marine business were stable in 2010 at £2,591 million (2009 £2,589 million) reflecting a five per cent decline from original equipment, as the subdued order cycle began to impact deliveries. This was offset by further services growth, with underlying revenues 11 per cent higher in the year benefiting from a growing installed base and new services centres commencing operation around the world.
• The energy business made significant progress again in 2010 with a 20 per cent growth in underlying revenues to £1,233 million (2009 £1,028 million), and is now more than 60 per cent higher than 2008.

Underlying profit margins before financing costs reduced slightly from 9.7 per cent in 2009 to 9.3 per cent in 2010. The reduction in margin reflected changes in revenue mix, higher levels of research and development charges, increasing costs associated with the launch phase of major new programmes. In addition, the performance reflected the net impact of a number of positive and negative one-off items in the year including the Aviall distribution agreement and costs associated with the Trent 900 failure on an Airbus A380 which offset improvements in operational performance and productivity and the benefits of better achieved foreign exchange rates in the year.

Underlying financing costs reduced by £13 million to £55 million (2009 £68 million), primarily a function of lower finance costs associated with financial risk and revenue sharing partnerships as one of the major arrangements came to an end in late 2009.

Restructuring charges in 2010, totalled £46 million down £9 million from the prior year. These costs are included within operating costs.

A final payment to shareholders of 9.60 pence per share, in the form of C Shares, is proposed, making a total of 16.00 pence per share, a 6.7 per cent increase over the 2009 total.

The order book at December 31, 2010, at constant exchange rates, has remained resilient at £59.2 billion (2009 £58.3 billion). This included firm business that had been announced but for which contracts had not yet been signed of £4.5 billion (2009 £6.8 billion).

Aftermarket services agreements, including TotalCare® packages, represented 31 per cent of the order book, having increased by more than 40 per cent in the last three years. 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 13 per cent on an underlying basis in 2010, reflecting increasing installed base of products across all four markets, expansion of the global services network, especially in the marine sector, and some encouraging signs of improving trends in the discretionary service spend in some large civil engine programmes. Underlying services accounted for 51 per cent of the Group revenues in 2010.

In particular, TotalCare packages in civil aerospace now cover 70 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 £920 million (2009 £970 million).

There was a cash inflow in the year of £258 million (2009 £183 million outflow) and an improvement in average net cash balances to £960 million (2009 £635 million). A modest increase in underlying profits combined with a strong working capital performance offset more than £800 million in investment in product development, operational facilities and tooling and the acquisition of ODIM ASA in the year.

These total cash investments of £842 million (2009 £688 million) in intangible assets, property, plant and equipment and acquisitions together with payments to shareholders of £266 million (2009 £250 million) and tax payments of £168 million (2009 £119 million) represented the major cash outflows in the year. The net cash balance at the year end was £1,533 million (2009 £1,275 million).

The overall tax charge on the profit before tax was £159 million (2009 £740 million), a rate of 22.6 per cent (2009 25.0 per cent).

The tax charge on underlying profit was £236 million (2009 £187 million) a rate of 24.7 per cent (2009 20.4 per cent).

The overall tax charge was reduced by £29 million in respect of the expected benefit of the UK research and development tax credit. The underlying tax rate is expected to be around 25 per cent in 2011.

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 of negotiation or litigation. The Group believes that it has a duty to shareholders to seek to minimise its tax burden but to do so 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 following a policy of full disclosure in order to effect the timely settlement of its tax affairs and to remove uncertainty in its business transactions. Where appropriate, the Group enters into consultation with tax authorities to help shape proposed legislation and future tax policy.

Transactions between Rolls-Royce subsidiaries and associates in different jurisdictions are conducted on an arms-length basis and priced as if the transactions were between unrelated entities, in compliance with the OECD Model Tax Convention and the laws of the relevant jurisdictions.

Before entering into a transaction the Group makes every effort to determine the tax effect of that transaction with as much certainty as possible. To the extent that advance rulings and clearances are available from tax authorities, in areas of uncertainty, the Group will seek to obtain them and adhere to their terms.

The changes made to the Group’s UK pension schemes over the last few years have enabled the deficit to remain stable and modest. The charges for pensions are calculated in accordance with the requirements of IAS 19 Employee Benefits. The Group’s principal UK defined benefit schemes employ a lower risk investment strategy in which the interest rate and inflation risks are largely hedged and the exposure to equities has reduced to less than 20 per cent of scheme assets. As reported last year, the primary objective of the revised investment strategy is to reduce the volatility of the pension schemes to enable greater stability in the funding requirements. Over the last two years our three major defined benefit pension schemes have increased the assumed life expectancy of members and pensioners but, even after allowing for these changes, the overall funding level across these schemes has improved.

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. The net deficit, after taking account of deferred tax, was £593 million (2009 £590 million). Changes in this net position are affected by the assumptions made in valuing the liabilities and the market performance of the assets.

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 (R&D) investment amounted to £923 million (2009 £864 million). Net R&D charged to the income statement was £422 million (2009 £379 million). The level of self-funded investment in R&D is expected to remain at approximately four to five per cent of Group revenues 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 an increase in the level of net R&D charged within the income statement in 2011.

The continued development and replacement of operational facilities contributed to the total expenditure in property, plant and equipment of £361 million (2009 £291 million). Investment in 2011 is anticipated to increase compared to the 2010 level as the investments in new facilities in the US and Singapore continue.

Investment in training was £33 million (2009 £24 million).

The Group carried forward £2,884 million (2009 £2,472 million) of intangible assets. This comprised purchased goodwill of £1,108 million, engine certification costs and participation fees of £496 million, development expenditure of £630 million, recoverable engine costs of £346 million and other intangible assets of £304 million. Expenditure on intangible assets is expected to reduce modestly in 2011, largely as a result of the status of development programmes. Intangible assets of £211 million arose during the year as a result of the acquisition of ODIM ASA.

The carrying values of the intangible assets are assessed for impairment against the present value of forecast cash flows generated by the intangible asset. The principal risks remain reductions in assumed market share, programme timings, increases in unit cost assumptions and adverse movements in discount rates. There have been no impairments in 2010. Further details are given in note 8 of the financial statements.

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 partnerships.

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 common 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 partnerships (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 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 engine 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. Partners share financial investment in the programme, typically through:

• market risk, as they receive their return from future sales;
• currency risk, as their returns are denominated in US dollars;
• sales financing obligations;
• warranty costs; and
• where they are manufacturing or development partners, 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 in the accounting policies in the financial statements.

In 2010, the Group received other operating income of £95 million (2009 £89 million).

Payments to RRSPs are recorded within cost of sales and increase as the related programme sales increase. These payments amounted to £198 million (2009 £231 million).

The classification of financial RRSPs as financial instruments has resulted in a liability of £266 million (2009 £363 million) being recorded in the balance sheet and an associated underlying financing cost of £13 million (2009 £25 million) recorded in the income statement.

The Group also receives government launch investment in respect of certain programmes. The treatment of this investment is similar to non-financial RRSPs.

The Board has an established, structured approach to risk management. The risk committee (see governance) 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. These are reviewed and updated on a regular basis, with risk mitigation plans identified for key risks. See Principal risks and uncertainties.

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.

During the year, the Group reviewed and amended its credit and short-term cash investment policies to reflect the state of the credit market and to ensure the Group can continue to lay-off market risks associated with its business. As a result, the Group has revised the minimum publicly assigned long-term credit rating requirements for transacting financial instruments with a counterparty from Standard & Poor’s ‘A- ‘ to ‘BBB+’ (or the equivalent ratings from Moody’s and/or Fitch) to reflect the general lower level of ratings within the banking sector.

Deposits and investments in other debt instruments continue to require a short-term rating from Standard & Poor’s of ‘A-1’ (or the equivalent ratings from Moody’s and/or Fitch).

The most significant 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 risk committee report.

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 and manages its translational exposures through the currency matching of assets and liabilities where applicable. The matching is reviewed regularly, with appropriate risk mitigation performed where material mismatches arise.

The Group has exposure to a number of foreign currencies. The most significant transactional currency exposures are USD/GBP and USD/EUR.

The Group manages its exposure to movements in exchange rates at two levels:

i) 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 19 per cent of Group revenues in 2010 (2009 23 per cent). US dollar income converted into euros represented four per cent of Group revenues in 2010 (2009 two per cent).

ii) 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.

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 2010, the Group had US$20.9 billion of forward cover (2009 US$18.8 billion).

The consequence of this policy has been to maintain relatively stable long-term foreign exchange rates. Note 16 to the financial statements includes the impact of revaluing forward currency contracts at market values on December 31, 2010, showing a negative value of £336 million (2009 negative value of £144 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, on a similar basis to that adopted for currency risks, in accordance with parameters contained in written policies set by the Board.

Counterparty credit risk

The Group has an established policy for 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 Fitch, Moody’s, Standard & Poor’s, and other recognised market sources, and is reviewed regularly.

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 it 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 a short-term credit rating of ‘A-1’ from Standard & Poor’s or better (or the equivalent ratings from Moody’s and/or Fitch). Counterparty diversification is achieved with suitable risk-adjusted concentration limits. Investment decisions are refined through a system of monitoring real-time equity and credit-default swap (CDS) price movements of potential investment counterparties which are compared to other relevant benchmark indices and then riskweighted accordingly.

The Group’s borrowing facilities decreased during 2010 following the maturity of a US$187 million US private placement. As at December 31, 2010 the Group had total committed borrowing facilities of £2.10 billion (2009 £2.15 billion). The proceeds of the £500 million GBP bond issue in 2009 are anticipated to be fully used to pay down the debt maturities occurring in 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.

The Group’s £250 million bank revolving credit facility contains a rating price grid, which determines the borrowing margin for a given credit rating. The Group’s current borrowing margin would be 20 basis points (bp) over sterling LIBOR if drawn. The borrowing margin on this facility increases by approximately 5bp per one notch rating downgrade, up to a maximum borrowing margin of 55bp. The facility was not drawn during 2010.

There are no rating price grids contained in the Group’s other borrowing facilities.

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, 2010, 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.

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 governance section. 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. At the year end, the gross level of commitments on delivered aircraft was US$991 million, comprising US$618 million for AVGs and US$373 million for credit guarantees.

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 22 to the financial statements describes the Group’s contingent liabilities. There were no material changes to the Group’s gross and net contingent liabilities during 2010.

The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU. In 2010, the changes that have had the most significant effect on the Group’s financial statements are the revisions to IFRS 3 Business Combinations and amendments to IAS 27 Consolidated and Separate Financial Statements. These amendments affect the accounting for acquisitions and transactions with non-controlling interests and have been applied to the acquisition of ODIM ASA (see note 24 to the financial statements). There is no retrospective impact.

A summary of other less significant changes, and those which have not been adopted in 2010, is included within the accounting policies in note 1 to the financial statements.

In response to the financial crisis, governments and regulators around the world are considering various regulatory reforms to the financial markets with the aim of improving transparency and reducing systemic risk. While the proposed reforms are predominantly directed at financial institutions, some of them may have implications for non-financial institutions.

In particular, proposals by both US and European regulators to reform the Over-the-Counter (OTC) derivatives market could have implications for the Group in terms of future funding requirements and increased cash flow volatility, if parties to future OTC derivative transactions were required to clear such transactions via an exchange or central clearing and be required to post cash collateral to reduce counterparty risk.

During the year, the Company’s share price increased by 29 per cent from 483.5p to 623p, compared to an eight per cent increase in the FTSE aerospace and defence sector and a nine per cent increase in the FTSE 100. The Company’s shares ranged in price from 473.4p in January to 654.5p in November.

The number of ordinary shares in issue at the end of the year was 1,872 million, an increase of 18 million relating to the issue of shares for share option schemes.

The average number of ordinary shares in issue (excluding ordinary shares held under trust) was 1,846 million (2009 1,845 million).