Rolls-Royce's fitness drive hasn't stopped speculation about its future and whether the 'big three' of the aero-engine industry could soon be the 'big two'.
On 6 June virtually identical stories appeared in almost every British newspaper. Aero-engine maker Rolls-Royce, they said, could get a slice of a multi-billion-dollar order for up to 50 aircraft that was about to be placed by Singapore Airlines, the world's most profitable carrier.
It didn't. SIA did place $10.3 billion-worth of orders for long-haul jets - 22 Boeing 747-400s and 30 Airbus A340-300s - but the engine contracts went to Rolls's US rivals, Pratt & Whitney and General Electric, the other two of the 'big three' that dominate the world aero-engine industry. The hint by Michael Tan, SIA's deputy MD (commercial) that Rolls was 'certainly in the running' - the phrase which seems to have got the journalists going - proved empty. The only thing Rolls got was, predictably, brickbats from the same British newspapers which, only weeks earlier, had been building it up. Sir Ralph Robins, Rolls's chairman, would actually have been astonished if Rolls had won. It wouldn't just have been a tremendous coup, says Robins, it would have been a miracle.
That may be a bit of an exaggeration, but not much. The company was not in contention for the bit that went to GE - it doesn't yet make an engine of the right size for the Airbus A340 - and SIA has always used Pratt & Whitney on its 747s. When airlines are extending existing fleets the incumbent engine-maker is only rarely overthrown. It has been done - Rolls 'turned' Qantas from Pratt & Whitney to Rolls in the mid-'80s - but not often. Airlines go with the engines (and engine-makers) they know. 'SIA has never bought anything but Pratt & Whitney,' says Robins, 'and an airline that's so involved with a particular manufacturer is very difficult to turn over.' Particularly, he might have added, when the whole aerospace business is in recession. Competition among the big three, always intense, has been even more so over the past four years as the number of orders available has shrunk. The aerospace business has been hit by a double whammy. First the civil airline industry plummeted into what has turned out to be the worst and longest slump since the war. The International Air Transport Association (IATA) says its members have lost a combined $15.6 billion on international scheduled services alone over the past four years. Then, as the Cold War evaporated, military spending was chopped so that today it is probably 40% of what it was five or six years ago. All of which means hard times for the engine-makers. If the airlines (and defence departments) aren't placing orders for new aircraft then there are no orders for engines either.
To complicate matters even further, all three engine-widebody aircraft when the current crisis is over, have been pouring vast amounts of money into the development of mega-engines to power them. GE is working on the GE90, Pratt & Whitney the PW4000, and Rolls on the Trent which recently achieved a world record thrust level of 106,000lb during tests. Between them the big three are spending around $4 billion on the new engines and doing so at precisely the time when the slump in business has hit revenues. They are doing it, also, without any guarantee that their investment will be recouped, which gives a whole new meaning to the phrase 'on a wing and a prayer'.
With so little work around and so many uncertainties it is perhaps not surprising that there has been speculation about major structural change in the industry. Observers ask the obvious question: if the market is so grim why don't the big three become the big two? Last year the Sunday Times reported 'secret talks' between Rolls-Royce and Pratt & Whitney about merging their interests in the big civil engines - those with thrust ratings of 100,000lb and more - and earlier this year there was a short-lived flurry of American buying in Rolls's shares amid claims that Rolls and Pratt & Whitney were about to merge.
There are at least two reasons why such speculation is not unreasonable. First, the present market share-out is weighted against Rolls. Secondly, there is the nagging worry that there simply will not be enough customers around for the new mega-engines.
The market share argument rests on the 'incumbency' factor which Robins says militated against Rolls in the SIA orders. Pratt & Whitney was the trailblazer in the commercial jet age so it still has a dominant presence in terms of installed engines. Probably two-thirds of the 10,000 or so commercial jets flying today use P & W engines, as against something under 20% for GE and around 14% Rolls-Royce - and being there, being the incumbent, always lends weight to bids for new orders. What Rolls-Royce would gain from an alliance with Pratt, so the argument goes, would be market access. Of course, current statistics could be used to mount a counter-argument. The 'orders in hand' figures show GE well in the lead (a result of its backing Airbus in the early days when others were sceptical) but have Rolls running level with Pratt & Whitney, rather than behind it. Extrapolate that forward 20 years and Pratt's advantage from being the incumbent is eroded.The other major consideration is what is going to happen to the mega-engines. Analyst Keith Hodgkinson of Lehman Brothers is an admirer of Rolls's recent performance, but tends towards the 'merger' camp, partly because of the 'market access' argument, and partly because he simply does not believe that there is going to be sufficient demand for the big engines (particularly in their very high thrust versions) to enable all of the big three to recover their development costs. 'There's only one aircraft at the moment that requires the thrust they've all developed of, say, 90,000lb or more - the Boeing 777. So they've all developed a very big engine at very great expense for one aircraft type.' Robins scorns any suggestion of merger. The British press is particularly adept, he says, at taking two and two in the aerospace business and making six. He believes there will be further structural change in the industry, but it won't be the sort of big-bang merger the pundits have in mind. Much more likely, he thinks, is that the smaller, second-division players, like France's Snecma and the German MTU, many of whom are already collaborating with GE, Pratt & Whitney and Rolls, will be pulled into even closer association with the big players.
There will also be more joint ventures among the big three. Rolls and Pratt are already partners in the V2500 which flies in the Airbus A320 and is on order for the A321 and the McDonnell Douglas MD90, and they are in constant dialogue about where such single-engine collaborations might lead. But having frequent talks with the Americans doesn't amount to getting into bed with them. 'We watch Pratt & Whitney very carefully, of course,' says Robins, 'and who knows what might happen in the future, but I'm talking about what real life is today, and there are no discussions.' Nor, he thinks, need there be. Look beyond the present ordering hiatus, he suggests, and there ought to be more than enough work to satisfy the appetites of all three of the leading players. Boeing, the world's biggest aircraft manufacturer, expects $980 billion-worth of new airliners to be sold over the next 20 years and analysts believe a revived civil engine market, including spare parts, could be worth $350 billion. Robins himself talks of $300 billion over 15 years. 'That's more than enough for three companies.' Robins may be bullish about the longer term, but probe him on immediate prospects and he is cautious in the extreme. The best he will say is that orders won't recover before 1996, if then. The key will be rising confidence (and profits) in the airline business.
Though Robins would not, perhaps, want to pin too much faith on them, there are tentative signs that the ordering cycle has now bottomed out. IATA is forecasting a combined profit for the world's airlines of $1 billion this year and SIA, when it placed its order in June said the deal was 'an expression of faith in the long term health of the aviation industry.' As for military spending, it will never again be the bonanza it was, but the consensus is that the procurement cycle has almost certainly now bottomed out and that recovery (modest as it may be) is on the way.
Given its reluctance to consider a major alliance with either of the other two world-class engine makers what is the outlook for a stand-alone Rolls-Royce? The group is much leaner and fitter than it was at the start of the present crisis. It has closed plants and slashed employee numbers from their 1990 peak of 66,000 to 43,000 to match the cost cutting of GE and Pratt & Whitney. It has also reorganised many of its operations to make them more customer focused, creating, for instance, separate companies for commercial aero engines, military aero engines and aero engine services. The idea is to make each of the companies and its management more accountable.
The way senior management thinks seems to have changed too. John Rose, deputy managing director of Rolls's aerospace division but due to take over as MD early in the New Year, says that something which should strengthen the group enormously is management's determination to bring both sides of the group's business, 'aero' and 'industrial' (industrial power now accounts for nearly 40% of group sales) into a more collaborative, almost symbiotic, relationship. The benefits of that strategy can already be seen in R&D where the emphasis now is on trying to see how much industrial benefit can be gained from the money spent on aero R&D. For example, Rolls will be introducing an industrial version of the Trent almost simultaneously with the Trent 800 in 1996. 'Historically, we wouldn't have done that,' says Rose. 'We'd have tended to develop the aero product and then subsequently develop the industrial product. But because there's now a sensitivity to the demand for an industrial product in that category, we did a simultaneous development.' The back-to-back aero/industrial approach is even spreading to manufacturing. Aero technology is going into the new generation of heavyweight gas turbines being developed in association with Westinghouse and the aerospace factory will be making the blades for it. 'We'll be making a blade which is orders of magnitude bigger than anything we make for aero products but using the same techniques,' says Rose. 'We're focusing on getting advantage from the money we're spending within the aero business and spreading it around the entire business, getting it into as many markets as we can.' Looking for pointers to Rolls's (and the wider industry's) recovery most lay observers will naturally enough keep their eyes open for the big 'headline' orders, like the SIA contracts. One of the next big ones is expected to be that placed by the Saudi Arabian airline, Saudia, which is talking to Boeing and McDonnell Douglas about large aircraft orders. But, in fact, just as important, probably even more so as far as profitability is concerned, will be a build-up in the spares business.
Outsiders are often surprised at just how vital spare parts are in determining the profitability of the engine-makers. Hodgkinson of Lehman Brothers estimates that the gross margin on civil spares is up to 80% compared with 20% on the original equipment. After deducting, say, 20% of revenues for overheads the operating margin on spares is 55% to 60% compared with nothing or even small losses on new big engines. Robins says Hodgkinson's figure for return on spares is a mite too generous but he does not dispute the analysis. Nor is it just spares that are important.
One of Rolls's big drives at the moment is to improve its share of the whole 'after market' - spares, repairs and maintenance. Modern engines need about $100 of maintenance for every hour they fly and that should provide an important revenue stream for Rolls. 'We're increasingly offering cradle-to-grave deals where we maintain the engines throughout their life and charge people so much money per operating hour,' says Robins. 'This is attractive to airlines, particularly start-ups, which are never going to have the facilities of the old ones, and indeed many of the old airlines are disposing of their equipment which is important for us. It drives the after-market back to Rolls without us having to go out and fight for it.' There is, however, a paradox about spares. The better you build the engine in the first place, the longer you have to wait to cash in on the spares. For instance, the RB211-535 has, largely because of its technical excellence, come to dominate the Boeing 757 market. Rolls now has 80% of all customers. But precisely because the engine is so reliable Rolls expects to wait anything up to seven years rather than the more conventional three or four before the engines start generating spares income.
Rose describes the spares business and repair and maintenance as 'an annuity' and, like the former banker that he is, does not mind waiting to cash in, provided the eventual out-turn is worthwhile. 'There are penalties for providing highly reliable engines but I think it's more a question of phasing than of absolute pounds.' Like Robins he believes that capturing as much of the after-market as possible is now vital to Rolls's long-term success. 'We're taking quite a lot of steps to do that. We've given the repair and overhaul business a great deal more autonomy than it's had historically and that's paying off in terms of its competitive approach. We're spending a lot of time, effort and brain power trying to ensure that we can get value out of the original engine sale over time.' Rose thinks the City is coming to understand the group better. First, it is assessing Rolls as a 'long-cycle' business. Second, people are starting to understand some of the benefits that will accrue to the group from its industrial power interests - a combination of the worldwide power engineering resources of NEI, acquired in 1989, and Rolls's own businesses in aero-derived gas turbines for marine and industrial applications and its interests in naval nuclear reactors. Chief executiveTerence Harrison says he would like to see the 60/40 split between aero and industrial evened up a bit. 'I think we'd like to see it slightly more balanced which would enable us to iron out the cyclical nature of both businesses.' Rolls, which is not one of the top 10 'industrial' players, is still seen by most observers as a niche player in industrial power. But that is rapidly changing. Traditionally, says Harrison, it was seen as concentrating on the old Commonwealth countries. It is now increasingly competitive in the developing world, and it has got more muscle by joining the so-called Westinghouse Alliance (Westinghouse, Mitsubishi and Fiat Avio) which is now the second-largest player in the gas turbine market.
Harrison retires in early 1996 so he, at least, will probably see his time out in an independent company. But can it last? Observers are wont to suggest that it is (understandable) pride, tradition, perhaps even a touch of ego that is keeping Rolls independent, rather than the logic of the situation. Sceptics will ask whether that is enough.
COMPANY HISTORY - Driven by the belief that they could do better.
Rolls-Royce was founded in March 1906 by Charles Stewart Rolls, an Eton-and-Cambridge-educated pioneer motorist who sold cars in Mayfair, and Henry Royce, a self-educated engineer.The two had met in Manchester two years previously just as Royce was testing his first car. He had built it after buying two French vehicles, a De Dion and a Decauville, and deciding he could do better. Rolls was so impressed that he negotiated a deal under which he had exclusive rights to sell Royce-built cars under the name Rolls-Royce. A year after registering the company they opened a factory in Derby to manufacture the six-cylinder 40/50hp Silver Ghost.
Rolls-Royce didn't enter the aero engine market until 1914 when, with the start of the first world war it was asked to manufacture the Renault V8 under licence. Having looked at the Renault 8, Royce decided he could put together something better himself - the liquid cooled V12 Eagle. The Eagle was the first in a line of engines that went on to power everything from Spitfires and Lancasters to Concordes.
In the late '60s and early '70s the company ran into financial difficulties and in 1971 it was declared bankrupt and reformed into two separate companies: Rolls-Royce Ltd, the former aero-engine division, which was established by the government and came under the control of the National Enterprise Board; and Rolls-Royce Motor Holdings Ltd, a public company, owned by the remaining shareholders. The latter merged with Vickers in 1980 and became a Vickers subsidiary. Rolls-Royce Ltd was privatised in 1987.
The aerospace group makes a wide range of engines for civil and military aircraft. Its customers include more than 300 airlines and 100 armed services around the world.
SUBSIDIES - US players' helping hand.
Rolls builds a wide range of engines and has an unparalleled reputation for technical excellence. But it cannot muster the political support that its American rivals can (the US Administration brings enormous influence to bear in negotiations with foreign customers) and it doesn't get government subsidies, while the Americans collect $700 million a year.'Our government wants to believe that out there is this very competitive world and that everyone's standing four square, and it's a level playing field,' says Terence Harrison. 'But it's not.'
ROLLS-ROYCE: FINANCIAL FACTS
Turnover/profit before interest* (£m)
Turnover Profit
Aerospace 2,139 20
Industrial power 1,379 68
Total 3,518 88
Turnover by origin
UK 3,161 80
Other 357 8
Total 3,518 88
Turnover by destination
UK 997
Rest of Europe 379
US/Canada 1,288
Asia 558
Africa 165
Australasia 81
Other 50
Total 3,518
Shareholders' funds (£m) 1,225
Number of employees 49,200
*for year to 31 December 1993.
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