Among the industries badly affected by the grounding of flights are the ones that manufacture the frames and engines of the airplanes themselves. Rolls-Royce, the more than 100-year-old firm with a market cap of $8 billion, has seen its civil aerospace business decline significantly in the past year. Recently, it announced its cash outflow in 2021 will fall below market expectations at about $2.7 billion, compared with analysts’ expectations of about $1.3 billion to $2 billion.

To learn why Rolls-Royce is facing such troubles with its civil aerospace business, GLG spoke with Douglas Scott, GLG Network Member and former Head of Business Development and Strategy at Rolls-Royce.

What are the sources of the issues that Rolls-Royce is currently facing?

When there are fewer flights and low flying hours, there is less revenue. Engines sold under service agreements rather than traditional financing methods have transferred a significant amount of operator risk to engine manufacturers. This has resulted in engine manufacturers experiencing a double hit — they miss out not only on the regular maintenance revenues but also the “embedded lease” payments for the engines that are baked into the per-hour flying rate.

Rolls-Royce (RR) is likely to be affected by this to a greater extent than GE Aviation and Pratt & Whitney, as its model has been to offer engines only under TotalCare to the exclusion of more traditional models. Secondly, the more complicated Rolls-Royce large engine architecture likely means manufacturing costs will be more than its competition. If this assumption is correct, it would result in RR’s margin on original equipment being lower than its competitors’.

What are your thoughts on Rolls-Royce’s current pricing model? Is this unique to the company or is it an industry-wide approach?

Competition among companies where a drive for market share is king results in pricing being forced lower and lower. The three-way battle through the 1990s between GE, Pratt & Whitney, and RR drove pricing on installed engines to such low levels that the businesses were required to collect a majority of returns in the aftermarket. This was combined with engine development requirements that kept engines on wings for longer periods, resulting in a model where there was little early revenue on installed engines until maintenance was required, further diminishing and delaying revenue. This created a vacuum that was partially filled by service contracts that collect flying-hour payments ahead of maintenance events. However, these contracts meant operational risk was passed to the engine manufacturers.

Is this a good model? No. The question should be why traditionally airframes are sold while engines are effectively leased from the manufacturers though service contracts. This creates a situation where flying hours become critical to recover revenue that would traditionally be collected on delivery of the installed engines.

Is there a systemic issue with Rolls-Royce’s design and marketing process?

There are always issues in any design process. If you are designing technology at the bleeding edge of capability, there will always be compromises that bias performance ahead of cost or serviceability. This becomes a problem when a business model is focused on aftermarket revenue.

Is the latest cost cutting likely to be effective for Rolls-Royce?

Rolls-Royce has a long history of cost cutting after every market crisis. The fact that each crisis initiates another round may hint at the likely effectiveness.

What provides the light at the end of the tunnel for the company right now?

The backstop provided by an ever-growing installed base of engines provides a near guaranteed future revenue stream for Rolls-Royce. Once flying resumes, engines will require maintenance, thus providing revenue. How profitable this revenue will be is debatable. Aircraft such as the Airbus A380 show that the traditional expectation of 40 years’ revenue from an engine program cannot be taken for granted. There should be a revaluation of the current business model that relies on the aftermarket return.

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About Douglas Scott

Douglas Scott is currently an independent consultant specializing in business and service strategy, with previous experience in financial analysis, strategic planning, and corporate treasury. Mr. Scott was previously the Head of Business Development and Strategy (Civil Aerospace) for Rolls Royce Plc, a position he held until 2008. During his 20 years with Rolls Royce, Mr. Scott created and developed the innovative WholeLife TotalCare engine asset service package, which financially benefits airlines by protecting the engine through its complete life cycle. Mr. Scott also directed Rolls Royce’s involvement in the business model research within an EU-funded VIVACE project that has been upheld as a model for future collaborative research projects, and negotiated the customer finance support commitments between Rolls-Royce and Boeing for the Trent 1000 engine, which is fitted to the Boeing 787 Dreamliner.