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Edited Transcript of RR.L earnings conference call or presentation 28-Feb-20 9:00am GMT

London Mar 12, 2020 (Thomson StreetEvents) — Edited Transcript of Rolls-Royce Holdings PLC earnings conference call or presentation Friday, February 28, 2020 at 9:00:00am GMT

* D. Warren A. East

Hey, good morning, everyone, and thank you for joining us here at the London Stock Exchange, and for those of you joining online. My name is Peter Lapthorn. I work in the Investor Relations team here at Rolls-Royce, and it’s my pleasure to welcome you to our 2019 results.

The agenda for today’s presentation is that our CEO, Warren East, will give an overview of the year’s performance and some of the strategic highlights. And then our CFO, Stephen Daintith, will take you through some of the more detailed financials. Warren will then wrap up and give his view for the year ahead as well as the longer-term outlook.

Our presentation is expected to take around 50 minutes, and then we’ll have time for Q&A, both from the audience and here online — and online. You can do online questions through the webcast services.

Finally, can I ask you to switch off mobile phones? We are not expecting any drills today. So if you do hear an alarm, please exit in an orderly manner.

I think that’s all of the safe harbor and the boring stuff out of the way. So with that, I will hand over to Warren East.

D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [2]

Thank you, Peter. Good morning, everybody. Thank you for coming along. I hope you enjoyed the video rolling while you’re having coffee and pastries out there, a little bit of subliminal messaging. And the picture of the electric plane on the front cover of the little handouts we’ve got there, we’re just 1 quarter away from flying that now. So some exciting highlights to come in the year ahead. But before we get there, I’m going to talk about 2019 to start with.

So here’s a summary, and we’re very pleased that we ended up with very strong progress across the group. We ended up with a strong finish to the year. It was a tough first half in 2019, but we saw very encouraging behavior changes around the group. And we could really see the effects of the transformation that has been ongoing within the company in some of the behaviors, which were necessary to drive that performance into the end of the year. So very pleasing to have an underlying operating profit strongly up, and that is really what’s underpinning the quality of that cash flow number that’s delivered as well. We have as a Board held payments to shareholders. There are some environmental risks out there, which I’ll be talking about in a little while. But in summary, a strong set of results.

Because 2019 was a year of delivery. In 2019, we delivered strong trading performance. We delivered significant progress on the Trent 1000. Trent 1000 has dominated a lot of the conversation about Rolls-Royce for the last 18 months. But actually, underneath that, and I’ll show you a slide in a few moments, we’ve had some excellent progress on that. Restructuring has been going on for a little while. But again, we’ve continued with the progress on that. We’ve continued with delivering on portfolio simplification, and we’ve delivered on our forward-looking strategy to capitalize on the upcoming energy transition and the journey to low carbon for the world at large. I’m very pleased with the momentum that we established, particularly in the second half of the year, particularly in Q4, particularly around the behaviors of our people. And that momentum has carried forward into 2020, and that underpins our confidence in 2020.

Stepping back and looking at the market environments, I’m just going to go around the 3 key areas of our business. So in civil aerospace, which is half of our business, we continue to build our installed base. It’s now over 5,000 large wide-body engines. Passenger air traffic demand has settled back to a steady state rate. We have had a few years of some quite superior growth, but it is, in 2019, more of a steady state, long-term trend. Build rates from airframers were adjusted during 2019, and as a consequence, our forward-looking projections of build rates for large wide-body engines has changed. In some ways, I think this build rate adjustment from the airframers has alleviated somewhat the concerns which were growing in the industry about oversupply. And so that’s actually quite a positive thing from a market environment point of view, and of course, it’s led by what’s effectively been slower-than-anticipated retirements over recent years of older aircraft. And I’ve got a little picture later showing pictures about retirements and so on.

In our Power Systems business and the sector there, we have had a cyclical downturn in the markets served by our Power Systems business, particularly following a pull forward a year or so ago from some of the traditional markets. However, from our point of view, we’ve seen encouraging growth opportunities in new applications and new geographic regions.

Defence, in our Defence business, after several years of pause, we’re now seeing new programs coming through from the key Defence customers, particularly the U.S. Department of Defense and here in Europe with the U.K. Ministry of Defence as well. And so the new programs are getting closer in the Defence environment.

Down at the bottom of the slide here, we’re on our journey towards 0 net carbon. And across all of our markets, our customers, we found in 2019, getting much, much more receptive to our thoughts on this. And we’re pleased to have, I think, established in 2019 a position of thought leadership.

Before I go into detail of the business, I’ll just build on that last point. Thought leadership in terms of leading a trend within our industry towards 0 carbon, taking the responsibility that we need to take for this, and that’s in products that face up to the market. It’s in the underlying technologies which feed those products, where we’ve seen great acceleration in our capabilities around electrification, for instance. We’ve seen progress on nuclear reactors with small modular nuclear reactors, a great source of 0 carbon electrical power. And we’ve seen a lot more industry engagement in the reality that the world needs to solve the synthetic, sustainable fuel challenge ahead.

Little bit of practicing what we preach on the bottom of the slide here for our own operations. This is a picture of our site in Friedrichshafen, where we have installed a microgrid. We’re starting to sell microgrids, but we’ve installed our own microgrid, and this solar-powered microgrid is generating about 30% of the energy requirements for our plant in Friedrichshafen. Enough of the future for the time being.

I’ll now have a quick update on what’s been going on in the business. So in our Civil Aerospace business, we’ve seen a year of sustaining improvement in underlying operating profit. If you look, that’s been happening over the last several years, and 2019 was no exception, a significant increase in underlying operating profit in our Civil business driven by the usual drivers that we’ve been tracking for the last several years. Customer confidence is pretty good as well. So from a forward-looking point of view, from orders coming in through the door, approximately nearly, they’re [using] 2/3 of widebody new orders in 2019 coming to Rolls-Royce. From an operational point of view, our operations are getting into much better shape. We’re improving performance there, improving stability, improving cycle times, and generally improving performance. It’s not just about our wide-body engines in civil aerospace. We do have some exciting programs in business aviation as well. And in 2018, we launched the Pearl family of engines. The first Pearl family engine entered into service in 2019, and the second Pearl family engine was launched in 2019. That’s going to power the new Gulfstream aircraft.

In Power Systems, I mentioned from a market point of view, there’s a bit of a downturn in the sector served by our Power Systems business. And so we were encouraged to be able to grow our business into that environment, grow our business at the top line and grow the profitability of our business. And how do we do that? Well, we did that through targeting new applications, the newer applications, particularly strong in mission-critical power, backup power, and also by pushing hard on developing our business in what’s new geographic regions for us and particularly in China. And it was great on some of the new technologies as well, to see progress on things like microgrids and hybrids. And that hybrid, I’ll probably come back to a bit later in the presentation. But in the space of 2.5 years, we’ve gone from concept to proposal to MOU to order to, in the next several months, delivery of Hybrid Rail PowerPacks. So very solid progress from our Power Systems business.

Defence. Defence, the standouts for 2019 in Defence was about orders, another year of record book-to-bill, taking our order book to a record level as well. And it was another good year for delivery of cash. In the background, I mentioned we’re getting closer to those new programs. So actually, our R&D is going up a bit. So you will see the margins coming off a bit over the next couple of years in Defence, but we’re capping off a period of 4 to 5 years of building the order book. And over the last 5 years, book-to-bill has been above 1x. And so our future in Defence, particularly driven by some of the service contracts, is in — looking like very good shape.

Now I know that everybody wants to hear a bit more about Civil than they do about Defence and Power Systems, so we’re going to have a couple of deep dives on Civil. I can’t stand here and not talk about Trent 1000. Obviously, we did a little bit of an update in November. And in the results announcement this morning, you will see no change from what we announced in December. No change in terms of projected return of AOGs to single digits, no change in exceptional costs and so on.

During the year, we made some pretty good progress, good progress in actively managing the situation, continuing to extend our MRO capability and our MRO capacity. And we are confident that, that GBP 578 million of cash cost in 2019 is the peak year of cash costs for Trent 1000. So we are beyond that peak. As we look forward in 2020 to single-digit position around the midyear, then we’ll be underpinning that with more spare engines as we announced in November.

On the histogram here on the bottom of the chart is about just that reduction in aircraft on ground. And you’ll see in 2019, we had to take a step back, and we took a step back proactively by — because we needed to pull forward a replacement of intermediate pressure turbine blades on one of the variants of the engine. And having originally generated indigestion in our MRO network and having been eating off some of the indigestion, we then generated [the load] more and so pushed the AOGs down again, and that effectively pushed out the period when we’d get back to single digits. But there has been no further deterioration on that since we announced that in Q4 last year, so we’re currently sitting around the mid-30s in terms of disruption.

This slide is an update of the slide that we showed in November, which summarizes the 3 engine [marks] for Trent 1000 and the 3 key issues, and we are now in a position of 8 out of 9 of the design changes are done. We’ve got one there, the Pack B IP compressor waiting to be certified. There’s no change to that design. We’re totally confident that, that will get certified. It’s simply a question of priorities in terms of the fact that that’s the last one. Other than the final box over there, where, as we said in November, the design work for the high-pressure turbine blade on the TEN, that’s still underway. As I stand here this morning, I’m a lot more confident than I was last November about that design work. It’s progressing well. And in the coming weeks, we will be running an engine with that new design. We’ll be going to type test, and hopefully, then on to certification.

The chart has been updated, though with these little pies to show that it isn’t just about doing the designs, it’s about rolling those designs into the fleet. That’s what minimizes the disruption and ensures a healthy fleet. And the pies on the left in each box, a snapshot of where we were 12 months ago, and the pies on the right in each box represent where we are today in terms of rolling those fixes into the fleet. So I hope you get a sense of momentum here of how the fleet is getting healthier as we go.

So moving on, it isn’t all about Trent 1000. Trent XWB has now reached 5 years in service. And the leading engines are surpassing our expectations in terms of durability, in terms of performance. It’s our most reliable engine, and its efficiency holds up very well in service. So the airlines love it. And actually, the customers love flying on the airplane as well. The 350 is a great airplane.

Points on the XWB. It’s today just over 10% of our installed fleet, but it’s approximately half of our wide-body deliveries. And it’s on a journey to be around 1/3 of our fleet in the mid-term. So this is a very important engine for us. So it’s very important that it has an outstanding record of performance.

There are other programs as well. I’ve already talked about the Trent 1000. Trent 700 is still our largest volume. It’s 1/3 of our fleet nearly. It’s the major workhorse of the Trent fleet. We’ve seen great progress over the years in extending the time on wing for the Trent 700, and so it’s a little bit of a benchmark and barometer for the newer engines that are coming along behind. And it’s an auspicious day today because it’s 25 years to the day that the first Trent engine went into service. It was a Trent 700 25 years ago on the 28th of February, and it’s still going strong after 25 years.

At the newer end of the spectrum, Trent 7000, and we put this up because the Trent 700 powers the A330, the Trent 7000 powers the A30 — A330neo. And we’re putting all the lessons we’ve learned from the Trent 1000 into that engine. It is based on the same architecture as the Trent 1000 TEN. But putting all the lessons in, then we are confident in the performance of that engine.

Looking a little bit further forward at our installed base because it’s the size of our installed base that underpins the medium-term business confidence. And the size of our installed base is about new airplanes going in, it’s about older airplanes retiring. And this chart shows that actually, if you look at the older airplanes that are going to retire, i.e., the ones on the left-hand side of the slide at the bottom, it’s dominated by our competitors. And at the right-hand side of the slide, the present day, you see our market share. And you recall, our market share in terms of orders, approximately 2/3 of the orders in the last 12 months, for instance. So we think we are well positioned through this retirement cycle that is going to be coming up over the next several years, well positioned to continue to grow our market share, and that underpins the installed base.

Enough of deep dive on civil. By the way, the clock in the bottom — in the back of the room, guys, has stopped working at 9:07. So I’ve just realized that it’s actually 20 past 9. So sorry about that. We’re now going to move on to — I thought, blimey, it’s going slowly. Change and transformation. Change and transformation is at the heart of creating a higher performance business, which is capable of delivering quality results. And over the last 18 months or so, we’ve seen great change in the management. We’ve seen change in pace. We’ve seen change in process and the development of a forward-looking strategy. So we now have a very different business than we had a few years ago to face the challenges that are around today.

Just recapping some of what we talked about on the Capital Markets Day in 2018. We talked about simplifying our organization structure, streamlining processes and investing in automation to enable our people. So during ’18, we sorted out the structure. During ’19, we made great strides in terms of reducing process, removing duplication and installing automation to enable our people. And that’s carrying on in 2020. So A&M are continuing to help us to actually deliver the benefits of this transformation. But basically, we are on track for what we set out at the Capital Markets Day, delivering what we said we were going to deliver, and that’s measured in some ways by achieving run rate savings. And if I look, for instance, some specifics, product change process and end-to-end digital design, that sort of reduction in engineering hours, that sort of improvement in productivity is baked into our plans. And that frees up resource to concentrate on the future. And I talked about improvements in our operations earlier. There’s a focus area there, and I think other good indications are the change in trajectory of that inventory that we saw halfway through the year, demonstrating a sharpening up in our operations. And in our service business, we’ve had to grow our MRO capacity. But the good news is we’re growing our MRO capacity faster than our investment in MRO because we’re getting better and smarter at doing it.

So improved productivity across all these 3 areas, and these are the fundamental 3 areas that make our business tick, we’re either developing this stuff or we’re building this stuff or we’re looking after it when it’s in service. And why are we doing all that? Well, we’re doing it to position our business for the future. At the Capital Markets Day, we talked about bending the cost curve, and this is a focus on R&D, for instance, but bending the cost curve, reducing the cost as a percentage of sales. So in the R&D domain, that means effectively keeping our R&D flat as the sales grows. And within that fixed envelope, you can see here how we’re tilting the amount of money spent towards future-looking technologies. So that’s why we’re doing this transformation so that we can position the business — we can deliver the business performance and position ourselves for the future.

So with that, I’m going to hand over to Stephen to talk about our 2019 numbers in a bit more depth.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [3]

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Thank you, Warren. Good morning, everybody. So I’m going to take you through the full year results, give an update on the key drivers that we first highlighted back in the middle of 2018 at our Capital Markets Day, then we’ll go through a quick review of each business, and then we’ll go into guidance for 2020. So just running through these.

So at a glance. We gave ourselves a lot to do in the second half, but with the — we’re pleased to be reporting today a strong underlying operating profit growth of 25%. And what’s most encouraging about this, this is the core driver of the growth in our free cash flow, and we’ll see that again in 2020.

Moving on to free cash flow, GBP 911 million. So driven by that growth in profits. And especially strong performance in the Civil Aerospace aftermarket. We’re going to see shortly the Civil aftermarket cash margin and how that’s developed over the last couple of years. We also received, very late in the year, some insurance receipts in respect of insurance that we had in respect of grounding of our wide-body engine fleet, and we could claim against that on the Trent 1000. At the — we have been negotiating these for well over 12 months, this particular insurance arrangement. And we reached the conclusion of those negotiations towards the end of the year. And hence, the receipts, which arrived in right at the very end of the year as well. So at the halfway through the year, limited visibility around that and not much certainty.

Civil Aerospace. We saw a strong improvement in operating profit in Civil Aerospace as well. It’s the first time that we’ve seen profit in Civil under IFRS 15. As a reminder, that came in at the start of 2018, we no longer capitalize the losses on the OE sales. And so very encouraged to move to operating profit in civil aerospace.

And finally, gross debt reduction. We reduced our gross debt by GBP 1.1 billion. Reporting today a net cash position, this improved to GBP 1.4 billion. An important priority for us. We’ll come into the details a little later, to strengthen our balance sheet and return to a single A rating.

Let’s go to the revenue slide. Revenue business by business. Our delivery in 2019 was in line or better than guidance for every business. I won’t go through the exact numbers, but you can see there in the blue just to the right of center, what we guided a year ago. And then the middle there, the growth for each business. Really solid growth in Civil Aerospace, 10% growth driven by both OE and aftermarket. Strong growth in Power Systems, and we’ll go into the detail, in a challenging market. Defence growth, in line with guidance. And good growth in ITP, which we’ll go through shortly when we go through the business reviews, but largely driven by increase in Civil Aerospace volumes.

Moving on to profit, and there’s the profit profile for each business in 2019. And again, margin guidance that we gave a year ago met or exceeded in every business. A relatively modest margin in Civil Aerospace, but moving into profitability. Power Systems back into double-digit territory. Defence, increased investments in R&D, as Warren mentioned, causing that drag. And ITP, good improvements in margin in ITP, largely around our simplifying of the contractual relationship between ITP and Civil Aerospace, with ITP very much now as a full-fledged member of the group and very much a traditional parts supplier to Rolls-Royce. And we simplified those contracts there. So good performance in operating profit and a strong performance in particular into the year-end, especially in Power Systems that delivered on much of the projects that have been built up during the course of 2019.

Moving on to free cash flow. So we had a strong end to 2019 following a challenging first half, and just 3 or 4 items here to just call out that helped us deliver this good free cash flow. Inventory reduction. We’ll go through the detail very shortly, but a very significant inventory reduction in the final quarter. Disciplined spend control as well. You’ll see that today we’re reporting C&A costs down 4% year-on-year. That was another good achievement, largely around discipline around discretionary spend. Capital expenditure was also down year-on-year, and good discipline there as well, but driven largely by some large projects coming to their conclusion during the course of the year, and I’ll go through that detail. And as I just mentioned, the Trent 1000, we secured those insurance receipts. What’s not included in this list is a strong Civil aftermarket performance as well in the second half, and we’ll see that when we go into the details of the long-term contract creditor and how that moved year-on-year. We also saw in our cash flow an improved quality as well. There’s a materially lower contribution from net receivables/payables, still a large contribution, but materially lower than last year, and I’ll talk about that in a second.

Cash return on invested capital was stable at 12% and that’s despite our R&D investment being at the highest levels of cash spend of GBP 1.1 billion per annum. And the chart down the bottom shows a material free cash flow improvement from the low base of 2016 when we were generating just GBP 100 million of free cash flow. So bear that GBP 800 million improvement in mind, which I’m going to come to as we go through the cash drivers of performance that we first highlighted in the middle of 2018.

So when we look at those drivers of cash flow, and we break them down, looking at our summary funds flow statement, looking at the balance sheet movements, tying that in with operating profit, here is the composition of our free cash flow improvement of GBP 305 million. And what’s most encouraging is that GBP 507 million of that was driven by operational cash flow improvement: increased operating profit; the growth in the Civil deferred revenue balance, that long-term service agreement creditor on the balance sheet represents deferred revenue cash receipts that haven’t been traded through the P&L account; and then lower CapEx as certain large projects have come to a conclusion. R&D cash spend is stable, so it’s not through any reduction in R&D that these numbers are being delivered.

A lower working capital contribution of GBP 50 million is a headwind. And the peak year for the Trent 1000 costs of GBP 152 million is also a headwind, and that includes the insurance receipts as well. So you put all that together, you get to your GBP 305 million. And it’s color-coded there, which matches this next table, which goes through the summary funds flow statement itself to show you how we’ve allocated the individual lines to deliver those numbers. So that’s how the maths all works.

Working capital improvements. Now just on this one as well because it does attract a lot of attention, and often it’s regarded as always bad, which is far from the case. First of all, in the second half, we saw a GBP 390 million reduction in inventory. That was the task that we had ahead of us at the half year after that big build of inventory in the first half of the year. Civil Aerospace and Power Systems had particularly strong fourth quarters. There’s been a tight focus on supply chain management that will continue through 2020. The buffer inventory that we built up on the Series 1600 in Power Systems, as that production moves to India, that will start to unwind. The sales and operations planning process in Civil Aerospace. I think I’ve mentioned previously, a lot of room for improvement there. We’re starting to see the signs of improvement, it’s taking place more regularly with a smaller number of people perversely working a lot better than all the various committees that often cause complications there, but that’s a lot more efficient as well, and that’s helping drive that inventory improvement. We expect to see the vast majority of working capital contribution in 2020 from further inventory reductions.

We have just over GBP 4 billion of inventory on our balance sheet, about half of that is in finished goods, which ought to flow through quite quickly. There was a GBP 574 million increase in net receivables and payables. Our Defence business had a very good year for cash flow generation, driven by that strong order book intake of just over GBP 5 billion and GBP 200 million contribution towards that GBP 574 million. And then another example here of what I regard as good working capital management, a more disciplined collection of overdue debts, reducing those from 20% to 15% of trade debtors. And driving that GBP 130 million contribution. So don’t be surprised that there’s more of this in future years. There should be. This is good, healthy discipline. And these are what I would regard as durable working capital improvements.

So putting this together, we have a significantly improved cash position at the year-end. We have year-end net cash of GBP 1.4 billion. That’s led by that group free cash flow number of GBP 873 million. Of course, we received the Commercial Marine and Power Development proceeds in aggregate of GBP 453 million. There was a GBP 1.1 billion reduction in gross debt as we repaid the GBP 500 million bond and then the EIB loan as well. We have one maturity in 2020 of $500 million bond in the second half of the year, and we’ll consider whether to refinance or retire that bond in due course. That gives us, together with the cash that we have in our revolving facility of GBP 2.5 billion, that gives us almost GBP 7 billion of liquidity. We do, though, have a credit rating challenge right now, given where we are, and we have a strong ambition to return to a single A rating. We highlighted this as a strategic priority for us in 2018, and it remains, and we are very much determined and focused to get back to that rating. It will be around operational delivery and delivering the Trent 1000 fixes and demonstrating that we’ve retired that risk.

So the progress on the key levers. These are the 3 key levers of cash flow growth that we first highlighted in 2018 at our Capital Markets Day, and they remain as true today as they were then, and they will be for the next 5 years as well. So what are they? First of all, reducing the loss on our OE wide-body deliveries. There was a further improvement in the year of around GBP 200,000 per engine in the reduction of the loss. The XWB-84 leads the average loss reduction. There’s been a GBP 400,000 improvement per engine since 2017, which was the base year that we’re comparing against from when we first unveiled these drivers in 2018. So let’s just use 500 engines, GBP 400,000 improvement per engine, that’s around a GBP 200 million improvement from this particular initiative.

The wide-body aftermarket cash margin delivered a further GBP 300 million improvement, moving from GBP 1.6 billion to GBP 1.9 billion aftermarket cash margin. That’s a GBP 500 million increase since the — over the 2017 base. It’s worth reminding ourselves as well that in 2018, our 2022 goal for the aftermarket cash margin was GBP 2 billion. And we’re already at GBP 1.9 billion. This should grow further as aftermarket flying hours grow, but also as we extend time on wing and the gaps between shop visits as well, a core priority for us in Civil Aerospace.

And then finally, bending the fixed cost curve on the right-hand side there, and this is the aggregate of commercial and admin costs, R&D and CapEx put together. Right now, we are 280 basis points lower as sales reduction during the course of the year, which in aggregate brings us to around 400 basis points lower since the 2017 base.

So put all that together, that’s about GBP 100 million contribution there. So it’s not — the maths isn’t quite exactly the same. But the point is if you add up the GBP 200 million, the GBP 500 million and the GBP 100 million from those 3 key drivers, you get to an GBP 800 million improvement over the last 2 years, which happens to conveniently be the free cash flow improvement as well, although they are — there is a mixing of drinks a little bit here, but it gives you an idea of the direction and the contribution from these 3 key drivers.

Here’s a bit more detail on the wide-body engine deliveries, 510 in 2019, a record year for deliveries. That’s how the profile of losses has improved over the last 3 years in the top right there. Worth pointing out as well on the deliveries, the big pickup in volumes of the Trent 7000 in 2019 versus 2018. So very small, just 2% of the pie down there, Trent 7000. And on the right-hand side, 21% Trent 7000 deliveries. Just calling out on the left-hand side here, the Trent XWB-84, we saw a 22% reduction in OE losses. And by the end of next year, we expect the XWB-84 to be a breakeven engine.

The aftermarket cash margin has now moved from GBP 1.6 billion to GBP 1.9 billion. This is driven by — on the — above the horizontal line there is the cash coming in. That’s just wide-body, 15.3 million engine flying hours, and then — from the 5,000 installed engine base. And then down at the bottom there, are the costs that go out during the course of the year in respect of the major refurbishments. That’s the scheduled every 5 years-or-so shop visits. The check and repair visits are the sort of more the case is sort of ad hoc depending on specific instances. And this one, for example, is where most of the Trent 1000 check and repair visits in respect of the issues that Warren ran through is going through that line in there, and then there’s various other costs as well. So delivering ahead of our Capital Markets Day ambition, at GBP 1.9 billion, and within touching distance of the 2022 goal.

On the right-hand side there, the key drivers of growth, 7% engine flying hour growth in the year. Strong time and material growth as well. We’ll see this shortly in the Civil Aerospace Profit and loss account, 14% growth. Yield improvements as well. And growth in pay at shop visits events. Now this is important. There are many of our customers who prefer to be paid at the shop visit rather than through the flying hour process. That has a higher yield per flying hour than had they just paid as the hours were generated, but it’s an important dynamic.

This is an important slide, and it’s a reminder of the trajectory that Rolls-Royce is on to become increasingly a services business. It’s a reminder of our installed base. When you add up the Civil Aerospace installed base of 14,000 engines, the Power Systems installed base of 146,000 and then 16,000 in Defence, the 176,000 engines driving this service revenue. And you can see the makeup there of long-term service agreements, GBP 3.8 billion and other services of GBP 4.1 billion, growing at 13% and 8%, respectively. So now representing 52% of our revenues and a growing source of revenues with recurring, visible, higher-margin business. And so a lot more certainty around these revenues from this large installed base.

Key initiatives for us to drive higher returns: extending the time on wing in civil and defence aerospace, the point that I mentioned earlier, which will only help improve the aftermarket cash margin; optimizing repair technologies; and increasing use of digital capabilities, better predictability about the health of the engines and when they’re going to be required to be serviced and how quickly to turn them around.

Bending the fixed cost curve. C&A costs were down 4% year-over-year. Capital expenditure was down GBP 158 million year-over-year, beating the guidance that we gave as those large projects came to completion. C&A costs, I’ve mentioned. You can see the charts there. Just as a reminder though, R&D is at its highest levels at just over GBP 1.1 billion of cash spend. And then you can see the progress that we’ve made as a percent of sales for each of those lines of the cost curve.

Trent 1000 in-service cash costs. 2019 is the peak year of those cash costs, gross cash costs of GBP 578 million before the benefit of that GBP 173 million of insurance receipts, and you can see the profile that we’re expecting and guiding to over the next 3 or 4 years.

So a quick run through our businesses. Operating profit of GBP 44 million in Civil Aerospace, driven by wide-body OE — sorry, driven by OE revenue growth of 4%, services growth of 14% in equal measure across LTSA and time and materials, still a very healthy source of high-margin business for us, delivering that 10% overall, driving gross profit improvement and subsequently the operating profit that we’re reporting today.

Our Power Systems business. Good revenue growth in what are challenging markets. You’ll see some of the others in this sector having — reporting less — much lower revenue growth than Power Systems has experienced. Good growth in Power Systems in power generation and good opportunity in China, where we see good progression there as well.

Our Defence business, pretty much as we guided. Underlying revenue broadly stable at just 1% growth, a little bit of a margin decline given that increased investments in research and development, but some good opportunities for that business in its pipeline. And we’re hopeful for even more big order wins in 2020 for Defence, but a really knockout year for our Defence business. And I should call out here the very high cash conversion in our Defence business driven by those big order wins and a big contributor to the cash flow performance for the group. So an outstanding year for our Defence business.

And then finally, ITP. ITP is a business now full — fully-fledged member of the group, reported very good revenue growth of 21%, largely driven by aerospace volumes. As a reminder, ITP is a risk and revenue sharing partner on certain Rolls-Royce engines but also on Pratt & Whitney and GE engines as well. So it’s a partner to various players in the aerospace sector. The operating profit growth was partly driven by a GBP 25 million one-off benefit in respect of the adjustment of those trading terms between Civil Aerospace and ITP to better simplify arrangements between the 2 companies.

So moving on to the guidance for 2020. Underlying revenue. We’re looking at Civil Aerospace revenue being stable to low single-digit growth, very much driven by that revision to OE volumes, 450 to 500-or-so engines in 2020. Power Systems, low single-digit growth anticipated there. Defence, stable to low single-digit growth. ITP — and ITP stable at GBP 936 million.

And on operating profit. Civil, growing by 50 to 100 basis points improvement in margin in Civil Aerospace. But as a reminder, we’re guiding today that our R&D — capitalized R&D will be between GBP 100 million to GBP 150 million lower in 2020 than in ’19, and that will mostly be in Civil Aerospace. So one might think that, that’s a slightly low-margin improvement in civil, but we should bear that into mind. Power Systems, further margin improvement there of another 100 basis points. Defence business, stable. And then ITP, a small margin improvement there as well.

Operating profit growth. Putting all this together of at least 15%, and that gets you to around GBP 1 billion of operating profit in 2020.

Core free cash flow of at least GBP 1 billion, and I should call out that this guidance excludes any material impact from COVID-19 in 2020.

How does that bridge to cash flow, profit and — oops. So how does that bridge from profit to cash? So here are the big moving parts. GBP 1 billion of operating profit, the core driver of the free cash flow growth. The LTSA deferred revenue, we think, will be broadly stable year-on-year at around GBP 750 million. Capital spend above depreciation and amortization, again, broadly stable at GBP 600 million. Working capital contribution of GBP 600 million in 2020, but reinforcing my earlier point that, that will be led by inventory unwind, and I think around sort of 3 quarters or so of that GBP 600 million being in inventory unwind. The movement in provisions, around GBP 500 million. That’s largely the Trent 1000 that you would expect. And then other, tax, interest, pension, broadly stable at around GBP 250 million. And that’s how we get to our GBP 1 billion of free cash flow, at least GBP 1 billion of free cash flow in 2020.

With that — I should add one more thing. There’s other more detailed guidance, by the way, in the appendix of the slides that you’ve got here around various other drivers.

With that, I’ll hand over to Warren. Thank you.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [4]

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Thanks, Stephen. Okay. Right. I’m going to look forward a little bit more. Earlier, I talked about momentum, and I talked about momentum around changed behavior and changed levels of performance. That continuing momentum coming in from the second half of 2019 is what gives us the confidence in 2020. As Stephen said, little footnote here on the left-hand side of the slide, and the guidance that he just stepped through, and in fact, all the guidance that we have in our earnings release, is subject to the fact that it excludes material impact from COVID-19 in 2020. But that said, we would expect our operating profit growth to be around 15%. The number that Stephen mentioned and at least GBP 1 billion of free cash flow in 2020.

Importantly, we look through COVID, because we see the fundamental drivers of the business, and that’s what’s driving our confidence in GBP 1 of free cash flow per share in the midterm.

Now I’m not going to ignore the COVID situation at all. We’re taking it very seriously. And what’s important is what we’re doing to manage the situation as far as our business is concerned. So our priority is, of course, our own people, and we have daily monitoring of the situation in all of our locations, and that’s coordinated and comes into our Chief Medical Officer, who reviews that situation every day. We’re also doing daily monitoring of the business risks, and the business risks break down into what’s happening potentially to our revenue and importantly, although we’re not a business that is subject to lots of just-in-time deliveries and that sort of thing. It’s important that we keep a daily track on our supply chain. And that is — that’s what we’re doing at the moment through our supply chain leadership. This is clearly 1 of those known unknown situations. The things we don’t know are how long the disruption is going to go on for and to what extent the disruption is going to spread around the world. So here on the bottom of the slide, we’ve got a few data points so that you can scope out some of the potential impact to our business. I say potential impact because, of course, the third unknown is the extent to which we’re able to mitigate the damage should there be material damage. Here are some parameters. Chinese airline customers, it’s about 10% of our backlog today. Flights touching China is about 20% of our engine flying hours. How much of that should we take into account. I can’t tell you. But what I can tell you is that year-to-date flights touching China are down by approximately 15% between the 15-ish percent in January and 50% in February. So I can also tell you from our daily monitoring of the supply chain and our daily interaction with customers through our Power Systems business that operations in China are getting back to normal. Our key suppliers. We have a handful of key suppliers in China. These suppliers are all back at work, and we have had actually no interruptions in our Civil Aerospace supply chain as a result of the shutdown there. So that’s kind of the scope of the situation. The monitoring of the situation that we are doing. And in terms of contingencies and how we can mitigate against that. Well, we’re the same as any other business. So we look at the financial impacts, and what can we do about deferring expenditure, what can we do about deferring investment, what can we do about deferring or freezing hiring, and what can we do about the actual staff costs that we take on a day-to-day basis. And like any other business, we’re pulling on all of those levers. So that’s the situation as far as COVID is concerned for our business. COVID is a reality, and we have to manage through that. And I say manage through that because though it is a reality. And I mentioned earlier, I think we’re in better shape than we ever have been to deal with that reality. We must look beyond and looking beyond, takes us to our priorities for 2020. Customer priorities are very clear about meeting our commitments and about getting the Trent 1000 AOGs down.

From an operations point of view, we need to continue the improvements that we’ve made over the last 18 months or so, particularly driving towards achieving the GBP 400 million of run rate savings. Having successfully changed the trajectory on inventory. We need to continue driving that forward. From a financial point of view, obviously, the emphasis is on quality of cash and strength of operating profit. And from a people and culture point of view, we need to build on the fantastic changes that we’ve seen, embedding those behavioral changes, building on the encouraging momentum that we have seen.

So that, in the longer term, we can be a leader. We can be a leader in terms of behaviors. We can be a leader in terms of business performance. And we can play a leading role that we want to play in the energy transition over the coming decades in all of the sectors in which we operate, because we see that as a fantastic business opportunity.

And with that, I’ll stop, and we’ll hand over to Q&A. So who wants to go first?

We got one, we got one over there. That side.

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Questions and Answers

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Robert Alan Stallard, Vertical Research Partners, LLC – Partner [1]

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Rob Stallard from Vertical Research. A couple of questions, if I may. First one, easy 1 for Stephen. 2020 guidance, what sort of embedded commercial aerospace aftermarket growth rate have you built into your forecast and if you could break it down by long-term service and the time and material, that would be great. And then perhaps 1 for Warren and a longer-term question. You have cut your forecast for wide-body engine deliveries going forward. So you’re coming down from roughly 500 last year to potentially 400 in the out-years. What sort of impact does that have, particularly in terms of your targets for reducing the loss per engine on OE?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [2]

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Okay. So the Civil drivers. Well, we talked about 450 or so 450 to 500 engine deliveries. That’s a key driver. The average loss per wide-body engine. We’d hope to get that to around GBP 1 million per engine. So for the GBP 200,000 improvement. That’s the goal for us there. XWB, clearly on the road to breakeven by the end of the year. So average on that number will be sort of 0.2, 0.3 I would expect that sort of — that’s what we’re looking for. Engine flying hour growth, you should be thinking high single digits, 8%, 9% engine flying hour growth is a key driver for us. And then in number of shop visits, we did just short of 1,000 shop visits in 2019. And I would suggest that using something around 1,100, 1,200 shop visits is a good guide. Major refurbs roughly as it was in 2019 of between anywhere of 300 to 350-or-so, and then about 800-or-so check and repair visits is the rough composition of the — so those are the key drivers of the Civil profits and cash flow in 2020.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [3]

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And coming on to the wide-body deliveries. Yes, the wide-body deliveries that we would expect to make over the next several years is lower than perhaps the estimates we had a year or 2 ago. But what drives our business is actually the size of that installed base. And so we will still be at north of 6,000 wide-body engines in a few years. Because the size of the installed base is about the retirements and the rate of retirement as well as the rate of new aeroplanes going into the market. And the — so that’s the sort of key point.

The other point to bring out, of course, as you saw in Stephen’s presentation, our midterm ambition is underpinned by that aftermarket margin growth, the total aftermarket margin contribution, which we estimated at GBP 2 billion in 2022. And as Stephen just showed, we’re at GBP 1.9 billion in 2019. So we’re an awful long way through that process already. And in fact, we’re probably going to exceed our assumptions, and it’s those assumptions, which underpin our midterm ambition. And as for the volume and its impact on that trajectory of OE loss reduction, I don’t actually see a material impact by the difference in volume. This is not a hugely sort of high-volume activity anyway. And the costs are dominated by the costs of those components and the cost of the components is dominated by the design of those components. We continue to spend engineering effort on modifying designs to take cost out, we take cost out on an annual basis. And those plans are proceeding according — just unaffected by volume. You saw in the numbers that Stephen talked about. It’s led by XWB. I said XWB is half of the total volume. We will ship our first breakeven XWB in the fourth quarter of this year, which takes us to the average that Stephen mentioned. And we are confident of achieving that.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [4]

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I can just — I didn’t answer your question about the LTSA split and the time and material split. I’d say, time and material. I mean, great performance in 2019, probably sort of high single digits-or-so in 2020. And the LTSA, the number of — volume of shop visits, clearly is a key driver there. But 1 thing to watch out for is that — and again, this is true in 2019 where we have Trent 1000 shop visits, check and repair visits that are related to the exceptional cost activity. We trade those costs through the provision that — and it won’t therefore, hit the LTC, the long-term creditor balance. So the deferred revenue is not reduced. The LTC balance is not reduced by those shop visits. If you see my point, which is a slightly accounting point, but — and that partly explains the growth in the long-term creditor this year.

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Celine Fornaro, UBS Investment Bank, Research Division – Head of EMEA Industrials Research [5]

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Celine Fornaro from UBS. I was just wondering if you could explain the mechanics through the Civil trading cash, which saw a nice improvement this year to GBP 400 million. And so how do we think about that for 2020 because potentially could be slightly worse. Depending on all the dynamics you’ve assumed? And then my second question would be on the 787 overall market share. And in terms of the recent announcement from ANA to go with GE and thoughts there on your assumption on potential volume on the TEN?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [6]

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Okay, do you want to have a go at the mechanics or shall I — shall I do the ANA one while you’re just [indiscernible]

So on 787, we look at it from a sort of fairly macro position. And it isn’t just about share on 787, it’s about share of wide-body orders, I think, approximately 2/3 of the wide-body orders in 2019 is a reasonable result. We are taking orders on Trent 1000 as well. Obviously, we are disappointed with the decision from ANA. We’re disappointed, but realistic. ANA already, 83 of their aircraft are powered, of their 787s, are powered by Rolls-Royce. And to be 100% dependent on Rolls-Royce when you have the choice is perhaps an unrealistic assumption when you get to a fleet that is growing at that sort of size. And so to have 15 aircraft and a few options going to GE is not something that particularly surprises us but, of course, we’re disappointed. We retain a very close relationship with ANA. And I think if you talk with them, you’ll find that they’re very pleased with the way in which we’ve handled the situation for their fleet, the importance of their fleet notwithstanding COVID for the Japanese Olympics this year. And in fact, in the next several weeks, all of their Trent 1000 powered aircraft will be in the air rather than on the ground.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [7]

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Sorry, and on the improvements in the Civil Aerospace, trading cash flow. Well, again, going back to those drivers of cash flow growth generally across the group. Our original equipment losses coming down and lower volumes at the same time as well. There’s going to be a contribution there. The aftermarket cash margin will continue to grow. Maybe I think a couple of GBP 100 million or so, there may be GBP 100 million or so from the first 1 that I mentioned. I haven’t yet mentioned business jets as well. Business jets had a very strong 2019 and is well placed for 2020. So we’re going to see some further improvements in the business jet contribution.

Trent 1000 costs coming down as gross cost, but of course, we don’t have the benefit of the insurance receipts. So that is a headwind there. And we are expecting further improvements in C&A costs generally across the group in 2020, building on the momentum that we developed in the second half of 2019.

Most of the headcount reductions in that we’re announcing today, the cumulative reduction of 2,900. I think 2,000 of those are Civil Aerospace. And you’re going to start to see that full year benefit of that 2,000 headcount reduction flowing through in Civil Aerospace. So putting all of those together, gives us confidence around further improvement in trading cash flow in Civil Aerospace.

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Nick Cunningham, Agency Partners LLP – Managing Partner [8]

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Nick Cunningham, Agency Partners. I apologize in advance because this is in grave danger of being nerdy. Both of my questions in fact. Thank you for the disclosure on factoring, which is really interesting. And I just wanted to try and understand it better in terms of how it moves across the year. And what the rationale of using it is, does it reduce the cost of capital and so on? And then second, I think probably equally nerdy, but possibly more generally interesting. If we look at the decarbonization, if you like, road map, how do you see that playing out in sort of very broad time scales and route to market? And what kind of mode of power source do you see developing?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [9]

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Okay. So let me cover factoring. And we are as you know, we’ve been very keen over the last few years to add transparency to our numbers and our guidance is pretty detailed, and we kind of explain our numbers at length as well. And an extra piece of transparency that we’re bringing today is our details of around invoice discounting or factoring as it’s otherwise known. And let me just explain where we are on this. It’s — factoring is a common place activity in the aerospace sector. We’ve been doing it for over a decade now. I would say 2016, though, was the first time that we materially got into invoice discounting, and that was largely around the time when the airframers changed their own settlement terms. And we introduced it to normalize the cash flows with physical delivery of engine volumes. So you’ve got a symmetry around those cash flows.

The last 3 years, it’s averaged at the year-end, it’s just over GBP 1 billion, as it does in this year. The way to think about it is that if we haven’t done any invoice discounting this year. Our cash flows will be GBP 95 million lower, which is the delta between this year’s activity and last year’s activity. But the average over the last 3 years has been, as I said, just — I think it’s GBP 1,037 million over the last 3 years. That’s the rationale for why we do it. It works well for us. And you’re right, there is a cost of capital attached to it, but it’s pretty modest, and it’s only for a short period of time as well because really, you’re just advancing November, December invoices into current year rather than waiting until January and February. So it’s only in place for a very short time.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [10]

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Okay. And the other 1 around the decarbonization road map.

I mean, obviously, I’m not going to be too specific on dates here and basic principle is that the smaller the aircraft, the more electric. And so we see an opportunity in the sort of helicopter size market disruption, new products for all-electric to hybrid. And then in the regional space, we see an opportunity for hybrid coming sooner than we do into the narrow-body space. So you have hybrid designs in the mid- to late 20s moving through to larger aeroplanes in the early to mid-30s. And then in the larger space, we don’t see an alternative to kerosene in terms of energy storage, but we do see opportunities for sustainable synthetic fuels. And there the decarbonization bit is all about the source of the electricity that’s used in the synthesis process. So clearly, it’s not very sustainable if the electricity comes from a carbon rich source. But as the world electrifies in a cleaner way, then there will be opportunities for clean electricity to generate synthetic fuel. We do see a potential role for hydrogen in that mix, and we are spending effort with some of our partners on exploring the opportunities for hydrogen, but it is going to be about the challenge of storing that hydrogen and again, about the clean source of electricity to produce the hydrogen in the first place.

Synthetic fuel is going to be limited by the ecosystem and the rate at which the ecosystem can develop and the faster it develops, the faster the cost will come down. The more the cost is up there, the more delay there is in that. And I suspect, as with any new technology, there will be a bit of a hysteresis, a tipping point, and then we’ll get there. And it’s important that we do things like UltraFan and more efficient gas turbines because whether we’re burning hydrogen or whether we’re burning synthetic fuel, there’s still a cost associated with producing that. And so the less of it that we can use, the better. And so we see a very firm role for UltraFan and more efficient gas turbines, whether they used directly for the UltraFan propulsion or whether the core out of UltraFan, the more efficient core is used in a hybrid application in a smaller aircraft. The project is absolutely vital.

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Harry William Freeman Breach, MainFirst Bank AG, Research Division – Research Analyst [11]

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It’s Harry Breach here from MainFirst. Could I just ask you, Warren, you touched on coronavirus in the slide earlier on. Can you just say — have you had any deferrals of delivery dates for on wing or spare engines that have been cited to be coronavirus capacity related? Secondly, if I remember well, and I probably don’t. Back in July at the interims. If I remember, you were saying that the breakeven date across the large engine deliveries, including spares, if I remember, was to 2023. Firstly, have I got that number right? And secondly, is there any change given your lower wide-body delivery expectations. And then just final one, maybe for Stephen. Stephen, just in 2019, for the civil aero LTSA revenue stream. Is it possible for you to just give us an idea of the pay at shop visit versus the sort of pay per flying hour monthly settlement?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [12]

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Yes. Let me kick off. We haven’t seen any deferrals attributed to the impact of COVID yet. But of course, that is a phenomenon, which is in the realm of our sort of planning and our sort of scoping the size of the potential impact from COVID, but as of today, we haven’t seen any of that. The breakeven point and the volumes. I mean, first of all, the volumes don’t make any difference as the answer to the previous question. Do you — you’re jumping in on something?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [13]

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Yes, I’ll happily go along this one. There’s a GBP 400,000 average loss per engine by 2022.

So I’m sorry, what was the number? you seem — [quoting] 2023?

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Harry William Freeman Breach, MainFirst Bank AG, Research Division – Research Analyst [14]

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[Those are — it was] across the portfolio for installed engine deliveries. [Integrate] even in [indiscernible] remember that date well.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [15]

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We haven’t actually — I mean, I think I remember a little bit the conversation where there was a slight bit of miscommunication from the presentation. You know, As Stephen says, the line that we are sticking to is just under GBP 500,000 across the portfolio by 2022. And the other data point that we’re sticking with is breakeven on XWB 84k by the end of 2020. And as I said, we will achieve that second one. It’s close we’re going to get there in 2020.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [16]

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Okay. And on the — sorry, the mix of shop visits as well. And I’m talking here around the sort of the major refurb shop visits.

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Harry William Freeman Breach, MainFirst Bank AG, Research Division – Research Analyst [17]

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[Let’s just say] revenues by pay at shop visit versus…

So I think my question has been just — I was trying to get at the for civil aero LTSA revenues, what the mix there was between the pay at shop visit part and the…?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [18]

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I would — okay, I’d hope for at least 20% pay at shop visit. Perhaps sort of the mid-high teens. And then the rest would be with flying hour. It’s a relatively — the important point — dynamic in 2019, we have 3x the number of pay at shop visits in the second half of the year than we had in the first half of the year, which somewhat explains the strong second half performance from cash generation on the long-term creditor that we’re seeing in the numbers today. That’s an important dynamic.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [19]

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Thank you. One — just pass it along, I think, is the best answer.

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Unidentified Analyst, [20]

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A couple of questions. First of all, presumably, the 97k is 1 of the big lose — big loss makers at the moment. Is there any reason why it shouldn’t get to breakeven like the 84?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [21]

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The — you’re right, the 97k is 2 years younger than 84 in terms of entry into service. And so that is 1 of the loss-making contributors. It will follow the trajectory. We — I can’t commit today that will actually get to 0. I mean, what you’ve seen because it depends how far out you take these things, and we put a lot of effort into extending the time on wing. It’s possible that we don’t want that to get to breakeven because it’s possible that we actually want to spend the money and have the components that improve the durability and the time on wing for service of and — a given engine because we actually make more profit out of that, than we make from trying to squeeze a technical profit on the OE. So generally, it’s a good idea to make as little loss as possible on the OE, but when you get in the detail and you get to the smaller numbers, then it might actually be better not to do that economically for the [program] and for the — for our overall profit.

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Unidentified Analyst, [22]

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The next question is a group of questions is, you’ve tripled the number of spare engines on the Trent 1000. How come it was so low?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [23]

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Capacity and capital. Simple as that. I mean, we — it’s a new engine. It’s obviously had issues. And the reason that we were able to improve the spare engines a little bit last year, and we’re going to take another big step forward this year is because we now have the capacity to do that.

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Unidentified Analyst, [24]

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[indiscernible] related to that, the — it must be a pretty tough job being the Trent 1000 salesman at the moment. Why on earth would any airline sign up to buy 1 right now, indiscernible [serious] question? Is there enough in your backlog to see you through to H1? Is there any chance of us seeing a Trent 1000 order this year?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [25]

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Yes. Well, I mean, there are Trent 1000 opportunities for us this year. And we do hope to take orders this year. Why would anybody do it? Well, because of the overall performance of the engine, the overall actual reliability of the engine. And the fact that actually, our competitor while having spare engines to protect against the disruption that we’ve seen, when you get in the detail, there are issues with our competitors’ engine as well. Now I’m not going to stand on the platform and talk about that. You can talk to Boeing, you can talk to airlines about their experiences of the engines on 787. But the answer is, we wouldn’t be taking the orders we’re taking now, if our engine was so bad that it was such a tough job being the salesman.

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Unidentified Analyst, [26]

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And the final 1 is bit of a philosophical one. A couple of years ago, you said that you typically had 4 in-service problems at any one time. It would take a couple years to sort out each and [one would solve them] [indiscernible] So there’s probably GBP 200 million-ish of cost underlying. With the Trent 1000, you’ve had 3 problems and it cost you GBP 2.5 billion. There will be undoubtedly in-service problems with your other indiscernible engines at some stage. How can you give us any reassurance that it’s going to be a GBP 100 million problem, not a GBP 2.5 billion problem?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [27]

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Well, and the answer, of course, is that we can’t give any guarantees but we can give assurances based on the very data that generated that original assumption in the first place. It wasn’t based on thin air. It was based on our experience of 25 years of the Trent engines. And that is the experience we’ve had and some of it does come of our own making when we’re trying to actually sort of extend the life of time on wing of the engine, and we’ve made great progress on Trent 700, over 25 years in doing that, but it hasn’t all been linear.

And sometimes, we end up with a great idea to extend the life or reduce the cost. And then 2 years later, in in-service, we find some issue. And those are the sorts of issues that I’m talking about that crop up regularly.

The Trent 1000 has been absolutely unprecedented in our history. That’s what everybody tells me. And we are grinding through it. Obviously, we’ve spent a lot of time and effort learning from those lessons. So we can take steps to minimize the probability of that happening again. I think if you look at the later engines, XWB is our example of the later engine, then, as I said, we’re fleet leaders at 5 years now achieving the number of cycles that they set out to achieve. And the airlines seeing excellent reliability during that process and excellent hanging on to the engine performance as well as it goes through time.

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Peter Lapthorn;Investor Relations Manager, [28]

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[indiscernible] quickly here with a couple from the webcast. We’ve had 2 on the LTSA creditor inflow from David Perry and Zafar Khan both asking it was an encouraging inflow in 2019, we’re guiding to a similar level in 2020, what might 2021 look like? And what are the drivers around that being a bit higher than previously thought. And then secondly, a quick — a second 1 from David on delivery guidance and whether we think 400 to 450 is the floor for wide-body deliveries?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [29]

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Okay.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [30]

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Do you want to do the first 1 or should I do the second one?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [31]

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I’ll do the first one. I’ll get the long-term creditor out of the way. So as a reminder, this is the balance on our balance sheet, the credit balance it’s the deferred revenue from flying hour cash going in there and then revenue gets traded through as the shop visits take place. We had a very strong second half, GBP 500 million better than the first half. In fact, there’s 3 or 4 key drivers of it. So first of all, engine flying hour receipts, good flying hour growth, but we also, as you know, we reconcile at the end of each quarter. The actual engine flying hours compared to the invoiced engine flying hours, and we do often see upside there. It’s not so straightforward as just number of flying hours flown. And it’s the type of flying hours as well. There are different prices around different parts of the flight experience. So that — it’s a pretty complicated reconciliation. We run that through, and we saw some good upside from that activity in the second half.

Pay at shop visits. We had 3x the volume of shop visits in the second half as we had in the first half. I talked a little bit about the high yield. That was a driver of growth as well, particularly strong business jet performance in the second half, which gives us encouragement for 2020.

And then finally, the — well, penultimate point, the GBP 100 million revenue catch-up that we had, that suppresses the drag — the [pullout] of revenue as well that we reported. And then the final piece is the number of Trent 1000 check and repair visits in the second half that goes through the provision, again, which isn’t hitting the creditor, but you’re still getting cash generated from those flying hours flowing through in any event. So those are the 4 or 5 key drivers. 2020, you’ll be thinking about the same sort of drivers. I think it’s too early to talk about 2021. What I would say though is that flying hour growth high single-digit sort of approaching double-digit flying hour growth is — it remains the fundamental principal driver of cash flow generation in 2021.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [32]

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And on the question of build rate and is our current estimate, the floor. Well, what I can say is that the current run rate supports the demand, the final demand, we have seen the demand fall to what appears to be more of a long-term run rate growth in demand. And I think if I go back 6, 12, 18 months, even. There was a lot more noise about overcapacity in the industry. And that overcapacity being ahead of that underlying demand, and therefore, there’s been a little bit of an overhang. And I think the build rate adjustments have been pretty, pretty well sort of expected.

Obviously, short term, we don’t know the impact in 2020 of the virus outbreak and the disruption that results from that, and what — to what extent that might spill over into some deferrals, I already answered that question. And so technically, there might be a little bit of deferral there. But actually, I can see more indicators to increase that demand for build rates. The underlying demand is going to carry on growing along with economic growth. And I think with the changes in sort of public opinion around flying, airlines are going to want to deploy cleaner, more efficient airplanes as and when they can afford to do so. So if anything, I can see a little bit of a sort of demand increase signal, but we’re not going to call that just yet.

I think we’ve got one — we’ve got the microphone over there. So we’ll come back to you. We’ve got about 4 minutes.

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Unidentified Analyst, [33]

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Yes, this is really, really [specific. Just standing.] If I’ve paid you for a flying hour, is there any way I can get the money back from you?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [34]

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No. Not typically. [Seeing] around the back of the bike shed. I mean, it’s a very good point because I know what you’re getting at here with the question because there is some commentary that the — we should regard the credit balance as debt. Will that — the cash is contractually ours and remains ours. Even if the airline stopped flying the planes forever. The cash is still our cash contractually. So that’s the way we should regard it.

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Unidentified Analyst, [35]

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[indiscernible] creditor, [let alone] debt?

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [36]

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It’s deferred revenue, it’s on the balance sheet as deferred income. Yes.

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Benjamin Michael Heelan, BofA Merrill Lynch, Research Division – Analyst [37]

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Yes. It’s Ben from Bank of America. Just one on the credit rating, you said you want to get back to A rating, what sort of metrics do you think we should be looking at in terms of that path, and what you think you need to get to A?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [38]

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We’ve had a lot of dialogue as you might imagine with the rating agencies, with both Standard & Poor’s and Moody’s on this one. I mean, [what] is very clear and their priorities align with our priorities. Operational performance improvement, delivering a high-quality operating profit growth and cash flow generation. If you’re looking for a metric, Standard & Poor’s, in particular, are looking for a 14%, 15% EBITDA margin. So that to get us to sort of move us into that single A rating category.

What I can say is that when we look at our plans, and then we look at the numbers that we’re talking around in the mid-term, we can see good progress over the course of the next 2 years on that ambition. And what is critical, though, is clearly derisking the Trent 1000. Warren talked about delivering that final fix on the high-pressure turbine blade on the TEN, getting it the design through in 2019 and certified in early 2021, and then we can start installing those blades, and we get the Trent 1000 back to a healthy engine. So that’s very much how the rating agencies are looking at it, and we know what we need to do, and we’re absolutely focused on it.

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George Zhao, Bernstein Ag – VP & Research Analyst [39]

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George Zhao from Bernstein. Could you talk about the CapEx spend needed in 2020 to build the spare lease pool engines to support the Trent 1000. And given that not all the fixes will be done by 2020. Is there concerns that you may need to continue to build more spares beyond next year?

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [40]

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So our CapEx was around GBP 750 million in 2019, and that includes an element, about GBP 100 million in round numbers of investment in Trent, in spare engines, a large proportion of which is Trent 1000. In 2020, we’re going to be maintaining the underlying spend, that’s before the Trent 1000 build, but we’re going to be increasing overall capital expenditure by GBP 100 million, GBP 150 million or so in respect of that additional engine build for the Trent 1000. And the way to think about this is that let’s use a proxy of GBP 4 million, GBP 5 million per engine, that’s about sort of 20 engines or so that we’re building in addition, in 2020. In addition to the 20-or-so that we built in 2019, if that makes sense.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [41]

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To answer, is there a danger that we’re going to have to build some more. What we’re effectively doing is pulling forward spares that we would otherwise have built anyway, as the size of the fleet grows. And so I don’t think we’re going to need to do an extraordinary number of spare engines. I mean, certainly, from an operational point of view, if we do the spares that we plan to do in 2020, then we should be able to protect the fleet. And then, over the subsequent years, we’ll grow back into that volume. And then we will continue to build spares as the size of the fleet grows. So I don’t anticipate any 2021 enormous step-up in the CapEx for more Trent 1000 spares.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [42]

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But as it stands today, this build of Trent 1000 engines will be a very good return on capital when we consider the cost that we’re currently seeing for every day that an aircraft is on the ground.

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D. Warren A. East, Rolls-Royce Holdings plc – CEO & Executive Director [43]

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Okay. It’s 10:30 on the clock. So let’s assume the clock is now telling us the right time. So thank you all for coming. I mean, the key takeaway messages here, I think it’s a strong set of results for 2019. Our performance to deliver on that, particularly after a very tough first half. As Stephen said, we left ourselves a lot of things to do in the second half. But the team has delivered and shows what this organization is capable of doing in terms of delivery.

I think COVID-19 and the disruption, which flows from that. This is a macro for everybody is a known unknown at the moment. We will keep you updated with the implications but we’re in pretty good shape on that at the moment with daily monitoring of the situation, daily contact with the supply chain. And we’re already seeing our suppliers and the customers with whom we deal in regions, which were first affected by the virus, i.e., Greater China, we are seeing a return to levels of normality there. But we look through that, and we can see the fundamental drivers of our business performance having improved. The fundamental levers that we talked about at our Capital Markets Day and before, we can see progress on that. We can see momentum, and we can see those drivers continuing. And that’s what underpins our confidence in the medium term. And we also want you to take away the fact that we’re not ludicrously short-term focused on GBP 1 billion in 2020 and GBP 1 per share of free cash flow in 2023. We are thinking beyond that as well. And developing a future for this business to build on that platform through the energy transition.

And with that, we’ll be back in July, late July to tell you about how we’ve got on in the first half of this year. Thank you.

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Stephen Wayne Daintith, Rolls-Royce Holdings plc – CFO & Executive Director [44]

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Thank you.

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