Pontifications: One “good” engine in future for RR, faulty business strategy and model: JP Morgan

Pontifications: One “good” engine in future for RR, faulty business strategy and model: JP Morgan

By Scott Hamilton

Feb. 7, 2023, © Leeham News: Our report last week about Rolls-Royce’s new CEO characterizing the company in dire straits is just part of the story. Shortly before that, on January 18, JP Morgan issued a 38-page dissection of the company that perfectly encapsulates what LNA has pointed out in the past about its commercial engine business.

JP Morgan’s assessment

JP Morgan looks at the entire company, while LNA focuses only on commercial engines. I’ll excerpt key points from JP Morgan’s engine section here.

  • RR has only one successful in-production widebody engine: The Trent XWB (A350) is a successful engine. We see very little prospect of the Trent 1000 (Boeing 787) clawing back the market share it has lost to GE in recent years. The Trent 7000 (A330neo) is likely to remain a niche product in our view. The Trent 700 should generate good [profits] for many more years, but from aftermarket activities only.
  • Some airlines might downsize from widebody aircraft to the A321 XLR: The Airbus A321 XLR is expected to enter service in 2024. This new variant of the A320 family will be capable of flying c4,700 NM, compared to c4,000 NM for the current standard A321. This is far less than the A330neo (powered by the Trent 7000) which can fly c7,200 NM. However, some airlines needing an aircraft to fly between 4,000 NM and 4,700 NM may now downsize from the A330neo and B787 to the much cheaper A321XLR. RR does not supply any engine for the A321XLR.
  • IAE royalties will end in 2027/28: In 2012, RR sold its 32.5% stake in International Aero Engines (IAE), which made the V2500 engine for narrowbody aircraft, for £942m plus royalties over 15 years. We estimate the royalties will total >£3bn; RR has booked these…since 2012. These royalties were due to end in 2027, but we understand that other V2500-related profits may continue beyond 2027. In 2022, we estimate RR’s Civil Aerospace…will include c£150m of IAE royalties and that these royalties could be closer to £200m from 2023 to 2027 (due to higher levels of flying hours on the V2500). We then expect the royalties/profit contribution to drop substantially.
  • No obvious route back into narrow body engines: RR still has ambitions to re-enter the narrow body market, saying it could enter a partnership with another company to do this. We see multiple challenges to this aspiration. (1) CFM International is already an established 50/50 JV between GE and Safran. (2) Pratt & Whitney has strong partners (MTU Aero Engines and Japanese companies) on its current narrow body engines…. (3) A partnership with a Chinese or Russian company looks unlikely given the geopolitical environment.
  • Can RR afford to invest for the next generation? The civil aero industry is currently enjoying a period of lower R&D as neither Airbus nor Boeing has any desire to develop an all-new aircraft in the next several years. But this is a temporary state of affairs and later this decade we expect Airbus and Boeing will try to develop much improved (and maybe all-new) aircraft to enter service in the mid-2030s. These are more likely to be narrowbodies, so perhaps RR will not be involved in a major way. But at some point, Airbus and Boeing will need to enhance their widebody aircraft and RR will need to decide if it is still committed to the sector.
Long-Term Service Agreements

Engine makers, RR included, don’t make money selling their engines. They make money on the parts and Maintenance, Repair and Overhaul (MRO) contracts. Or at least they used to. This business model has been increasingly under stress.

OEMs sold their engines at steep, steep discounts—up to 80% and in some cases, literally gave them to the buyer—in return for Long Term Service Agreements (LTSA). These covered MRO and parts purchases under long-term contracts. Accordingly, it takes the OEMs 10-20 years to recover development and sales costs.

But the reliability of previous generation engines, while a major selling point, became a double-edged sword. The very reliability meant fewer engine shop visits. Hence, revenues and profits began to fall at a slow, drip-drip-drip pace. The CFM-56 engine could go as much as 25,000 hours on wing, an astounding number. RR’s own Trent 700 on the A330 was good for around seven years on-wing before requiring a major overhaul.

But today’s engines are anything but as good in this regard. The problems with the RR Trent 1000 are well known. At one point, around 50 787s were on the ground due to failures in the 1000. Overwater operations were significantly reduced to flying near airports that could be used in an emergency.

CFM’s LEAP engine (the successor to the CFM-56) and Pratt & Whitney’s Geared TurboFan (the successor to the V2500) entered service in 2017 and 2016, respectively. There are reliability and durability issues with both. On-wing time hovers in the +/- 6,000 hour range.

The warranty work is hurting profits at the engine OEMs and causing executives to rethink how these are structured. There’s been some discussion about selling the engines for a more reasonable discount than historically.

Mispriced LTSAs

JP Morgan sees RR’s LTSAs producing fewer profits going forward. “We are increasingly concerned that RR may have mispriced its long-term service agreements (LTSAs) and that the future profit on these contracts will disappoint, for two reasons. First, the costs to maintain its engines are likely to be higher than expected when it priced many of the LTSAs. Second, we see challenges with RR being able to fully pass on all of its cost inflation on LTSAs to its customers,” JP Morgan writes. And RR has higher exposure to LTSAs than its competitors.

All-in-all, the outlook is dismal for RR and challenging for GE and PW. A major makeover in the overarching business model is needed.