Rolls-Royce should welcome a shareholder to its board

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.