In a recent
opinionated article (‘Rolls-Royce needs to quietly give activist investor the brush-off’), the FT defends the idea that Rolls-Royce, the British aircraft engine
maker, should refuse to grant ValueAct - an activist investor who has taken 10%
of the company to become its largest shareholder - a seat on its board.
I could not
disagree more.
Rolls-Royce
is without doubt a great high tech company and a crown jewel for Britain, but
it has also made some major strategic mistakes, faces profit decline and has destroyed
almost GBP 12 billion of shareholder value in two years. It has ruined its
Stock Reputation® (its reputation on the stock market) by failing to achieve
guidance on several occasions. The company can recover, but it needs the
support of its shareholders.
Strategic
mistakes, mismanagement and financial control failures
Rolls-Royce
is intrinsically a long-term business. Aircraft engines take many years to develop,
test and bring to market. Revenue from the sale of original equipment and
subsequent aftermarket services generate cash flows for decades. A successful
product delivers results for years, but similarly failures can have long-term,
negative implications.
Several
years ago Rolls-Royce made a massive strategic mistake. The company did not
propose a new engine for the A320neo, focusing instead on larger engines. Not
only did Rolls-Royce miss out on what is now the biggest commercial success of
Airbus (4,307 planes ordered at the end of September 2015), but it has also
marginalized itself for a long time on the medium-haul segment; the backbone of
the global aircraft market.
Unfortunately
at the same time, long-haul and large engines market growth has been
disappointing. Sales of A380, in which Rolls-Royce invested heavily, have
remained behind targets. The Airbus A330, which represents one third of the company’s
supplied engines, has reached end of life and its successor, the A330neo has
not yet taken over. The British company fell behind General Electric on the
market for the 787. As for the A350, for which Rolls-Royce is the exclusive
engine supplier, deliveries are still a mere trickle. Finally its Land &
Sea division, and in particular the Marine branch in which the group invested
significantly, has been strongly impacted by the oil price fall.
The Marine
branch aside, these challenges have been well known for years. The company
benefits from exceptional visibility provided by an order book representing
more than five years of revenue. Also, the expected profit decline of this year
should have been predicted, anticipated and managed. The necessary
restructuring should have been prepared and planned. Instead the company seemed
to suddenly discover such issues. In just over a year, the British engine maker
issued four profit warnings and almost as many restructurings, all the while
failing to deliver on its cost-cutting effort. This is a major managing and
controlling failure.
Board
responsibility
When faced
with such a situation, should shareholders remain quiet and passive? Should
they wait politely outside the boardroom? The FT believes so. It argues that it
is “the way these things should be done”, that directors have been
elected to manage the company, not to get distracted by vocal investors. “They
have a broader duty to advance the interest of the business as a whole over the
long term”, it says.
Rolls-Royce’s
corporate governance states: “The board is ultimately responsible for
Rolls-Royce’s management, general affairs, direction, performance and long-term
success. Non-Executive Directors should assess management performance against
agreed goals and objectives and monitor how those goals are reported. They
should satisfy themselves that financial information is accurate and that
financial controls and systems of risk management are robust and defensible.”
This is
true. Non-executive directors are responsible. If they cannot be blamed for
strategic mistakes (their seniority on the board averages at three years), they
are ultimately responsible for the company’s mismanagement and share price
fall. They are responsible for the control failures and multiple profit
warnings. They are responsible for Rolls-Royce’s ruined reputation within the
investor community. Had things been done as they should, they would have
assumed responsibility.
How an
active shareholder on the board can contribute to a re-rating
Beyond the
corporate governance argument, the FT does not see the value that ValueAct would bring to Rolls-Royce’s
board. Indeed the group, who has only recently appointed a new chief executive,
is facing major operational problems which cannot be solved directly by an
activist fund manager. Having one representative for the main shareholder among
the fifteen board members however cannot do any harm; quite the contrary.
First, it
would bring some ‘fresh air’ to the board. Rolls-Royce may be a global
corporate organisation, its board looks very much like an old-fashioned, cosy
English club. The board is composed of 80% British citizens including five from
Oxbridge, two Lords and one Lady. All have worked for large corporations, but
not one has been a global investor, had experience on the financial market or
has GBP 1 billion at risk in the company.
Second, a
powerful and active board member can bring significant improvements to the
board itself. Not only can they ask for the board to be renewed in order to
include more international personalities (American and European in particular,
to reflect the nationality of Rolls Royce’s main customers Boeing and Airbus),
but also reduce its size to make it more efficient and more accountable. They
can improve the executive remuneration system to align it more with the
long-term share price performance. They can ensure that the board truly focuses
on shareholder value.
Third, like
other non-executive board members, an active investor should not directly
manage the company but support the new CEO in his restructuring and
reengineering plans. Yet an active investor can contribute positively to the
strategy. One specific field in which they can be helpful is capital allocation
and investment strategy. Fund managers are experts in investment risk and
returns. They also know how to make a balance sheet more efficient with an
appropriate dividend policy and financing strategy. Rolls-Royce’s announcement
that it may cut its dividend sent both its share price and investor confidence
plummeting. Considering that the
group does not have a financing issue and a low gearing, any fund manager would
challenge this decision.
Fourth, an
investor who is constantly looking at the financial market and equity research
can quickly alert management to fast-changing economic trends. Rolls-Royce
might be a long-term
business, but it failed to predict the oil price fall. An investor, who is
better informed than most, may not have seen it but would have been in a better
position to anticipate it. Similarly, whereas non-executive directors base
their opinions mainly on information provided by the company, a fund manager
receives the support of a team of buy-side analysts who are constantly studying
the industry and the company’s competitors. Better protected from internal
influence and therefore more independent, investors are better equipped to
challenge management when necessary.
Last but
not least, an active shareholder on the board can help the company rebuild its
relations with investors
and Stock Reputation®. As part of Rolls Royce’s turnaround plan, the new CEO
rightly identified disclosure and controlling issues (lack of transparency,
inconsistent guidance, difficulties in predicting performance, etc.) and
announced a major change in forecasting systems. This is all great, however an experienced fund manager can
give valuable advice on how the company should determine guidance and
communicate to investors. They can
also play an active role in promoting the company and communicating to the
financial market. They can help convince investors to re-enter the shareholder
register and lead a re-rating.
At the end
of the day, the FT should remember that shareholders are not corporate enemies
but partners.
