Rolls-Royce and the Stock Market - Case Study Example

ROLLS ROYCE AND THE STOCK MARKET TABLE OF CONTENTS ROLLS ROYCE AND THE STOCK MARKET Pages Factors Affecting Economic Impact of 3-5 Stock Market and Inflation on Rolls-Royce Inflation and Economic Exposure 5-8 The Feasibility of Hedging Dollar Contracts 8-11 Alternative Strategies to Lessen the Need for Engine Contracts 11-14 Rolls-Royce and the Stock Market Factors Affecting Economic Impact of Stock Market and Inflation on Rolls-Royce Currently, Rolls-Royce plc (formerly Rolls-Royce Limited), based in Derby, is enjoying a high degree of success in the marketplace, even with longstanding competition from American companies Pratt & Whitney and GE, and part of the reason for their present success seems to be increased military contracts since 9/11 and investment in leading edge information technology within the company. They have also been working closely with General Electric, offsetting the competition element. Whether they are prepared for what will happen to the market in the future remains to be seen, but predicting the future of the marketplace at any given time is difficult at best, if not impossible. Factors that are apt to influence the market are inflation, exchange rates, government takeover and marketing needs. In this paper an effort will be made to determine why Rolls-Royce plc had such serious difficulties in the 1970s and how they either have, or should try to, offset any difficulties that might arise. Over the past 20 years, with successful deregulation and innovation in important areas of the economy, Britain has been doing well, and in keeping with that economy, Rolls-Royce has also been doing well. This was not always the case for the company. The 1970s were a time of instability for Rolls-Royce, so much so they almost went out of business completely, declaring bankruptcy in 1971. At the end of the decade, Rolls-Royce was in trouble again when their exchange rate predictions went awry. Could the company have foreseen the difficulties they would be facing in their engine production and was their financial crisis due to lack of foresight or a roll of the dice With empirical research, up-to-date news, government articles and papers on the business economy, an effort will be made to answer this question. Henry Royce built the first motor car in 1904 and joined with Charles Rolls to manufacture and sell a range of cars in Britain under the name Rolls-Royce. The company was formed in 1906 and within a year, the Silver Ghost, a six-cylinder car, was lauded as the best in the world. At the start of World War I, Royce designed his first aero engine, the Eagle, which provided half the horsepower used by the Allies in the air war. With the production of the "R" engine, business continued and Rolls-Royce gained the technological base to develop the Merlin, used in the Battle of Britain during World War II, and the gas turbine for the civil aviation market which led to the Comet, the first turbo jet to enter transatlantic service . In 1960 the Conway engine in the Boeing 707 became the first turbofan to enter the airline service ("History: Timeline, 2004; "The History of Rolls-Royce Motor Cars" [online]). Rolls-Royce was enjoying success as the only "British aircraft engine company that could contemplate competing in global markets" (Lazonick and Prencipe, 2004, p.6). In 1966, Rolls-Royce and Bristol Siddley merged and continued production of the Rolls-Royce aero engines in both companies. However, with each company retaining old loyalties, integration was never complete, perhaps creating the first crack in the veneer of the heretofore financially solid, growing business. At the same time, American Airlines in the United States announced a contest for a new trans-Atlantic aircraft. Both Douglas and Lockheed responded with designs, the DC-10 and the Lockheed L-1011, respectively. The designs were similar, using the minimum number of engines allowed, three. New engine designs were needed, and Rolls-Royce jumped at the chance to further develop an engine, the RB.211, already under development, to which a totally new piece of technology had been added. Lockheed was convinced the RB.211 was far and above the better engine and chose Rolls-Royce's design. This was very nearly the downfall of both Rolls and Lockheed when production costs for this ambitious new engine were much higher than expected and led Rolls-Royce into bankruptcy in 1971 ("Rolls-Royce RB.211," 2005). Between changes in the Lockheed design and necessary redesign of the LB.211, cost became prohibitive, but Rolls-Royce was a company whose management philosophy was mainly based on engineering capabilities, not the marketplace, and this unfortunately led to failure (Lazonick and Principe, 2004). Rolls-Royce's bankruptcy was such an unexpected setback for Lockheed that it never really recovered. The engine that caused all the problems, renamed the Tri-Star, continued to be developed when engineer Stanley Hooker, who had retired, came out of retirement to redevelop it, but it didn't meet market projections and production was halted in 1983. Following bankruptcy, Rolls-Royce reorganized and separated into Rolls-Royce Motor Holdings Limited, a public automobile corporation, and Rolls-Royce Limited, a government owned jet engine corporation. From 1971-1987, it continued as a nationalized company. Inflation and Economic Exposure In 1979, the company's financial situation worsened with "uncovered foreign exchange as the value of the pound appreciated under the first Thatcher government, as well as a prolonged strike" (Lazonick and Prencipe, p. 13). Rolls-Royce limited, British aero engine manufacturer, had been in competition with American companies Pratt Whitney Aircraft Group and GE's aerospace division for many years. In 1978 and 1979 Rolls-Royce won some huge engine contracts, but its operating costs were mostly incurred in sterling pegged to an exchange rate of about $1.80 for the pound, with the belief that the dollar would go down to $1.65. When at the end of 1979 the exchange rate was $2.12 for the pound, Rolls-Royce was unprepared, and suffered a loss in foreign exchange of as much as 58 million in 1979. The unexpected factor here was the election of Margaret Thatcher as Prime Minister. During her government, inflation was reduced but unemployment doubled between 1979 and 1980 ("Margaret Thatcher," [online]. Rolls, now a public company, no longer had the freedom to focus on research and development, and found themselves attempting to stabilize their financial base. The privatisation policy pursued in the UK by Thatcher's government (1979-1990) and Major's government (1990-1997) definitely had an adverse effect on research and development in the UK. Since Rolls-Royce has always based its priorities on innovation and innovative ability, Philip Ruffles CBE, retired Main Board Director for Engineering and Technology for Rolls Royce, when interviewed regarding the problems faced by the company under these two governments, said, "In the mid-1980s, at the beginning of this period, there was a shift of emphasis under the Thatcher government to cutting out costs in many areas as taxation was reduced," (Powell, 2005). A major problem in transferring Research & Development investment into profitable products and services in the UK, he went on to note, was a lack of focus on customer's needs. In exploring the role of innovation against the stock market, Lazonick and Prencipe confirm Ruffles' insight when they note that Rolls-Royce had extensive engineering experience but neglected value for shareholders (2004). They go on to explore the areas of the economy that must be addressed in a company like Rolls-Royce: top management support, financial commitment, functional integration, project championing and a clear market target (2004), and this may have been a time to try to create a more financially stable future. Over the years, it is obvious that Rolls-Royce has shown weakness in three areas, financial commitment, functional integration, and a clear market target, while excelling in innovation. In the meantime, Rolls-Royce's relationship with the United States and its tie-in with the American airline business temporarily had a negative affect after the events of Sept. 11, 2001, when hijackings triggered a steep drop in air travel, and "two of GE's biggest jet-engine clients, U.S. Airways and United Airlines, filed for bankruptcy-court protection, and others teetered on the brink. Demand for aircraft engines, parts and services slowed" (Kranhold, Reprint). The cost of developing new engines has greatly increased over the years, and engine manufacturers have been forced to collaborate on many projects in an effort to stay financially solvent. Ruffles (Powell, 2005) discussed this development when he said: The USA was already very focused on the private sector but this was to some degree offset by the enormous amount of government support that went into and is still going into areas of R&D such as the US Department of Defense or the Department of Energy. Such levels of government support have not existed in the UK for many years. (sec. 2, par. 3) A major problem, Ruffles noted, in transferring R&D investment into profitable products and services in the UK has been a lack of focus on customer's needs. "The whole R&D infrastructure, from academia and industry, is now more focused on the market than it ever was in the 1980s. . . . Money spent on research can be wasted if there is no route to market" (sec. 3, par. 1, 2). The USA , Ruffles went on to note, has a longer-term focus encouraged by government funding long-term projects; whereas in the UK, 100 percent funding is never available, requiring a more risk-averse approach. In a global economy and faced with labour shortages, a company such as Rolls-Royce cannot manufacture everything in the UK. It is necessary to access knowledge around the world. The Feasibility of Hedging Dollar Contracts If Rolls-Royce had hedged its dollar contracts when inflation and the unexpected devaluation of the English pound in 1989 caused them a major loss, the stability that occurred later might have carried them through a bad time. Even so, Rolls-Royce plc has managed to regain stability and at present is benefiting from a war economy. In an effort to foresee Rolls-Royce's future success, it is necessary to look at global affairs and how they have affected and might continue to affect the future. The UK marketplace has expanded into the global marketplace. Climate change, scarcity of fossil fuels, rising energy costs, and China as an emerging power must be factored into future plans. It must be noted that the recent strengthening of British-American relations during the Iraqi conflict will no doubt help Rolls-Royce now since "more than half of the 54,000 Rolls-Royce aircraft turbines in operation are installed on military aircraft. . . . Rolls-Royce has a number of risk sharing participations in military turbines (e.g., the GE F120), but it also offers a number of its own turbofans and turboprops for use in large military aircraft" (Minovi, "Rolls-Royce," par. 1). In a fluctuating world market, however, it is difficult to predict where problems will occur. Rolls-Royce was in a situation similar to this when they ran into difficulty in 1971. A war-driven economy made it appear that the company could look forward to many successful years, but that didn't happen. The cost of developing new engines has greatly increased over the years and engine manufacturers have been driven to collaborate on projects. The International Aero Engines Consortium was formed with Pratt and Whitney, JAEC (Japan), MTU (Germany) and Fiat; and Rolls-Royce has been working with General Electric on military engines, as well as becoming involved in other areas. In a recent news story from Washington, AP writer Lolita Baldor (2006) released a proposal by President George W. Bush to eliminate funding for the Joint Strike Fighter engine being built by General Electric and British Rolls-Royce. She said that British Prime Minister Tony Blair sent Bush a handwritten note, lobbying against the proposal. It will obviously affect the company adversely, but because Rolls-Royce has expanded its base considerably, it may not hurt the business that much. One area that Rolls-Royce has addressed that it had not addressed earlier is attention to customer base and market share. Research and development have always been their strong point but it isn't enough to offset changes in the economic overview if customer needs are not met. The economy fluctuates from day to day and trying to understand its workings requires an overview of the world market place. The use of the U.S. dollar as an international currency has been declining gradually for over thirty years. In the past several years, this reduction in the share of dollar reserves has accelerated with the decline in the value of the dollar and the rise of the euro as a legitimate contender for reserve currency status. In a world-market-driven economy, it is important for companies such as Rolls-Royce to consider a European consortium in an effort to gain economic sanctions if the euro continues to drive down the dollar. The economy, for many years, was dependent on two factors of production--labour and capital. This is presently being replaced by information and technology which can be considered the key factors of production ("Knowledge Economy," 2006). Understanding currency quotes is the first step in understanding how trading works. Foreign exchange is the purchase and sale of two currencies at the same time, and the quote will always be given in pairs. The base currency is the first listed currency, for instance, USD/CHF, dollars/francs. When the quote rises, the base rate strengthens in value. The base rate, normally the U.S. dollar, is set to a value of $1. "There are a few major pairs in which the dollar is not the base currency, such as the British pound (GBP/USD), the euro (EUR/USD), and the Australian and New Zealand dollars (AUD/USD, NZD/USD). If the GBP/USD rises in price, then the British pound is rising in purchasing power versus the US dollar" ("Understanding Forex Quotes, 2006). The same can be said for the euro. The Fx International Group offers the following explanation of the way the foreign exchange market works: Since most, if not all, of the transactions in the world involve currencies, the foreign exchange market has an incredible reach of influence into every financial facet such as the equities and bond markets, private property, and manufacturing assets. The currency rates determined by this market play a vital role in the financing of government deficits, as well as equity ownerships in real estate holdings and in other companies. The influence of the Forex market affects your purchasing power, hence your every day consumption decisions. ("Understanding Forex Quotes," 2006). A country's current account deficit and the relative attractiveness of U.S. financial markets have been the focus of discussion in the financial press, but the debate has now broadened to America's "unilateral approach to foreign affairs and decisions concerning the war on terrorism and the war in Iraq." Rolls-Royce has been working closely with America's General Electric, but perhaps it is time for the company to look elsewhere for its partnerships. A benefit that Rolls-Royce plc has retained over the years is the development of its "Trent" turboprop engine, which evolved into the first three-spool engine, the forerunner of the RB.211 series. By 1987, the RB.211-524L, a variant of the original, had been developed to such an extent it bore little resemblance to its predecessor. The newest Trent's advanced layout provides lighter weight and better performance compared to other competing engines. It allows it to be "fully scalable to the widest range of thrust of any current generation large turbofans" ("Rolls Royce Trent: Present Designation"). The company was privatized in 1987 and with strategic decision-making in a high-fixed cost, knowledge intensive industry, and by mobilizing the considerable financial resources to implement their decisions, the company has stabilized ((Lazonick and Prencipe, 2004, Abstract). What Alternative Strategies Might Have Lessened the Need for Engine Contracts By the early 1990s, Rolls-Royce had a 15 to 20 percent market share of the big commercial turbofans, even though GE and Pratt & Whitney were still out front. Rolls had the foresight to update the RB.211 which became the Trent and spawned derivatives capable of powering a wide range of airliners. The current engine is the Trent 1000 which was launched on the back of All Nippon Railways order for 50 Boeing 787s. The design has also been adapted for marine and industrial operations, and Rolls-Royce is presently the second biggest engine marketer in the world. Simply depending on engine contracts, however, may not be enough for the future of the company. Another area in which Rolls-Royce plc has excelled is in establishing innovative partnerships with key University research centres around the UK. It offers benefits both for the company and the students who have an opportunity to test new ideas. In 2001, writer Louis-Jacques Darveau wrote an article based on a story from Financial Times, in which it was said that the Rolls-Royce plc aircraft engines were being designed to power high-speed ships, and a month after that Rolls-Royce announced its acquisition of UK-based Vickers, the marine engineering and defense group. Darveau wrote the study of Rolls-Royce in an effort to determine if predictions for future mergers and acquisitions could be made based on Internet coverage, and concluded that regardless of coverage, predictions of this kind were too dependent on global circumstances. The Iraqi war is a case in point. Rolls-Royce has a tendency to take risks, which could lead them once more into the same predicament they were in regarding the exchange rate in 1979 that created for them a major loss. If foreign exchange markets are efficient, all anticipated relevant information should be incorporated in current exchange rates. Unanticipated exchange rate variations can therefore only be caused by unanticipated relevant information. Exchange rates fluctuate within relatively fixed limits, but predicting the direction of the changing rate is purely speculative (Galati and Ho, 2001). Daily movements in the euro/dollar rate are affected by macroeconomics in the United States and euro area. In 1979, Rolls-Royce made the wrong choice, but the market could easily have gone the other way. The company is still dependent on the value of the U.S. dollar against the pound, but as long as it has expanded its base to a worldwide market, the affect of any variation in the exchange rate should be covered. It must be noted that Britain has not signed into the euro and perhaps will not do so. If the UK should join will it give the country economic autonomy or will it mean isolation from Europe One certainty if Britain joins would be the binding of the UK with the rest of Europe, and Britain's economy would be dependent on the union. The only way to know the result is for the union to take place, and that could be disastrous for a country that has always stood alone. Rolls-Royce plc could benefit from such a union if the euro is strong against the dollar. Three million people are using euro notes, but in the UK, the debate is ongoing, and it is a debate that goes beyond this essay. Over much of 1999 and 2000 the euro was weak, but on December 20, 2005, a Europa press release announced that recovery in the euro area was gaining momentum, with GDP growth accelerating to rates above potential during the second half of 2005. The recovery seems to cover a broader base and short-term risks are more balanced than they were three months ago. Rolls-Royce plc is an innovative company which has increased its information technology to a point where they are a formidable global power. As long as they continue to be in control of leading edge technology, their future would seem to be assured. It is equally important, however, for them to stay abreast of the news and political events throughout the world. Staying ahead of technological advances, diversifying their interests, cooperating with other nations should keep them on an even keel. With the increase in the euro, Rolls-Royce should be evaluating possible partnerships in the European union, and looking to the future. References Baldor, Lolita C., "Bush to Propose Trimming Army Reserve" (2006), AP News: Washington, retrieved 1-29-2006, from http://www.fredericksburg.com/News/apmethods/apstoryurlfeed=D8FDJ9400.xml. Darveau, Louis Jacques (2001). 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