Thank you very much. Good morning. It's fantastic to see everyone here at my first results presentation as the Chief Executive of Rotork. Welcome to those of you joining us via Webex. I'm joined, as you can see, by Jonathan Davis, our Group Finance Director, as well as Martin Lamb, our Chairman, and Kathy Callahan, our Group HR Director, who are with us in the audience today. I'll start by providing an overview of the first half results, after which Jonathan will cover the financials in more detail. I'll return and provide more clarity as to my initial observations and our progress on the work streams that we've previously initiated. As you know, I started at Rotork about six months ago. Since then, I've been dedicating myself to engaging our global customers, experiencing the organization, and understanding how work gets done throughout Rotork.
Of particular interest to me has been identifying those things we do well and those things we could really improve upon. I've been pleased by the passion of the employees, the strength of our sales organization, and the depth of technology I'm seeing throughout Rotork. I've concluded we have a really good business. We can make it even better. I'm confident that we can continue to build upon what is a strong foundation. I see clear opportunities and potential for the future of Rotork. Our work streams have identified real opportunities for improvement, validating our ambition to deliver sustainable mid to high single-digit organic revenue growth and to return to the mid-20s margins over time, as we now shift from data collection and analysis into implementation and execution within our work streams. Let's take a look at our first half results.
Once again, we have delivered a very encouraging set of results. Our orders for the first half were strong, increasing by over 13% on an organic constant currency basis. Input was supported by increasing activity within our oil and gas markets, particularly evident in small to mid-size projects as we see a continuing return to more normal investment patterns around maintenance and operational upgrades. Larger project investments in oil and gas are also returning, yet still remain lower than historic levels and still somewhat patchy. Quotation levels for these larger programs remain high, driven by the stabilization of oil prices above $60 per barrel, coupled with major oil companies' multi-year efforts to reduce the costs of their large programs.
A general increase in automation across our other end markets continues to benefit all of our divisions, providing good growth opportunities in water, our growing HVAC market, and our industrial and processing market segments. Revenue strengthened throughout the first half, yielding nearly a 15% increase on an OCC basis. We finished the first half with a book-to-bill ratio of 1.1, representing an 8% increase in our order book from June month end of the prior year. Operating margins were also improved, rising 160 basis points to 19.8% for the half, despite inflationary cost pressures helped by contributions from service, new products, and a stronger emphasis on headcount management and productivity. At the half, our balance sheet remains in good order with strong cash flows helping to reduce net debt to under GBP 6 million.
All in all, a strong outcome demonstrating our continued ability to drive day-to-day execution while implementing the initiatives identified through our work streams. Let's have Jonathan walk us through our detailed first half financial results.
Thank you, Kevin. Good morning, everybody. Order intake and revenue were both positive in the second quarter compared with much stronger comparatives than the first quarter. The impact of currency diminished towards the end of the period, but was a 4% headwind over the six months. We've presented organic constant currency numbers to remove this impact. Adjusted operating profit of GBP 65 million grew 25.1%, and margins on an OCC basis were 160 basis points higher than H1 2017 at 19.8%. With a reduced net finance charge and a lower underlying effective tax rate, adjusted earnings per share were GBP 0.056, a 32.3% increase. The interim dividend is up 7.3% to GBP 0.022. The order book has grown by GBP 33 million in the period and is GBP 13 million ahead of June 2017.
Currency has had a minimal impact when comparing the current order book with last December, and growth is 17.5% at either set of exchange rates. The OCC adjusted operating profit bridge shows revenue growth has been a significant positive with the other direct costs a small net positive, but offset by growth in overheads. Materials were 20 basis points higher compared with H1 2017 with divisional mix, a couple of large lower margin jobs and controls, and a balance between sourcing initiatives and commodity cost pressures all reflected. Improving direct labor productivity and the fixed cost element of the factories more than offset the small headwind on materials. The OCC gross margin improved by GBP 22 million or 80 basis points. Overheads increased by GBP 8 million, GBP 5 million of the increase relates to people costs and the remaining GBP 3 million to IT recruitment and other costs.
Overall, headcount grew by 86 people or 2% in the period across all areas. We said in March we would be growing the number of service engineers, and these are 26 of the increase, with IT, procurement, and operations the other main areas. We started the year with net debt of GBP 12.6 million and finished the period with net debt of GBP 5.7 million. Tax and dividends are the two largest outflows in the period. The cash impact of restructuring costs is GBP 4.6 million, which is mainly consultants costs. Net CapEx was only GBP 4.4 million in the period. Work on the Bath site has yet to commence as we review the size and scale of the new factory to build in a suitable allowance for growth.
Working capital in the cash flow, which uses average exchange rates, is an outflow of GBP 2.4 million with inventory the largest component contributing to this movement. This has resulted in cash conversion of 100% for the period. CapEx in the second half is anticipated to increase to around GBP 10 million. Net working capital has increased GBP 3.9 million since December to GBP 192.2 million. Inventory is GBP 9.8 million higher and has increased as a percentage of revenue from 14.3% in December to 15.3% in June, which is the same as June 2017. Receivables have reduced by GBP 2.8 million since December, but are actually higher in terms of days sales outstanding at 66 days compared with 63 days in December. The pension scheme deficit has decreased to GBP 32.8 million, a funding level of 85%, due to changes in assumptions and the closure of the U.K. scheme to future benefit accrual.
Net debt of GBP 5.7 million represents less than 0.1 times EBITDA. The return on capital employed has increased to 27%. The adjustments to profit in the period comprise restructuring costs, a pension curtailment gain, and intangible amortization. The costs incurred in H1 are in line with previous guidance, which was that the run rate would be the same as the second half of last year. The restructuring costs are largely consultants costs incurred as part of our work streams, as well as some asset write-downs. The run rate for consultancy costs is expected to reduce in the second half of the year as we move into the implementation phase or add internal resource to support the growth acceleration program management office. At the same time, restructuring costs in respect to the three business sales/closures we have highlighted will be incurred in the second half.
In total, restructuring costs will be a similar level in the second half to the first half. The pension curtailment gain is an actuarial gain that arises from the closure of the U.K. defined benefit scheme to future accrual. This is a one-off adjustment and has therefore been excluded from our underlying trading results. Given the number of different elements impacting the outcome for the full year, I thought I'd summarize the guidance in one place. Given the much improved performance in the first quarter in particular, we anticipate a reduced H2 revenue weighting this year compared with last year, particularly on a constant currency basis. In March, we indicated we would be investing an incremental GBP 10 million in expanding our IT capabilities, site service resource, and R&D spend. Whilst this has started, the spend is H2 weighted, we'll see a greater impact of this in H2.
Cost savings generated from the earliest wave one procurement initiatives on travel, insurance, and some electronic components will benefit this year, but only towards the end of the year. However, in H2, the business sale and closures I've just mentioned will reduce overheads by circa GBP 1 million. Taking all this into account, we continue to expect adjusted operating margins to be slightly ahead of the prior year. The effective tax rate on adjusted operating profit is circa 100 basis points lower than the full year 2017 at just over 24%, primarily driven by the U.S. corporate tax reduction. The currency impact we referred to in March was a 5% headwind for the full year. If exchange rates remain at current levels for the whole of the year, the impact will reduce to around 3% headwind to revenue and operating profit. Turning to the operational review.
This slide summarizes the group's key markets and geographies. These slides are on an as reported basis. Revenue grew in each division, but the pattern by geography and end market was mixed. Oil and Gas was the fastest growing end market, which increased 21%. In total, Oil and Gas was 53% of revenue, with Downstream the largest and fastest growing area, now 27% of group revenue. Upstream grew nearly in line with group revenue, holding at around 17%, whilst Midstream declined. Industrial continued to perform well, up 16%, but Water and Power both declined, down 7% and 11% respectively. In terms of geography, growth was strongest in the Far East, but declined in the Middle East. The Far East benefited from increased spend in Downstream Oil and Gas, with the other end markets consistent overall with the comparative period.
The Middle East showed a decline in Power and Upstream Oil and Gas spend, both of which had been positive in the comparative period. Western Europe was the region with the strongest growth in Industrial, offsetting a decline in Midstream in this area. Turning to the divisions. In Controls, order intake was up 16% and revenue grew 13.4% on an OCC basis. Gross margins improved 50 basis points, but on an OCC basis were 30 basis points lower. Whilst productivity improved with the additional volume, material costs increased 40 basis points, reflecting in part increases in commodity costs, but also some large lower margin projects. At an adjusted operating profit level, OCC margins were 90 basis points higher, with the growth in revenue more than covering an 8% increase in overheads. Controls bears the largest share of the investment in IT, for example.
Controls Oil and Gas exposure is greatest in Downstream. The growth in that market has therefore benefited the division and boosted its sales, particularly in the Far East, and to a lesser extent, North America. Upstream and Midstream were broadly flat. Within this, Upstream was positive in Eastern Europe, but declined in the Middle East, and Midstream was positive in the Far East. Power declined due to lower activity in the Middle East and Far East, with North America reporting the largest reduction in Water. Industrial Process, including HVAC, grew as a result of a positive performance in Europe. Fluid Systems is still the division with the highest proportion of Oil and Gas sales and has seen a rebound in sales in the period. Order intake increased more in Fluid Systems than any other division, up 14.7% on an OCC basis.
Revenue increased by 20.6% as the improvement in order intake at the end of last year and in the first quarter of this year, particularly converted to revenue. This pickup in volume and a reduction in the material cost percentage of 80 basis points has driven an improvement in underlying gross margin of 410 basis points. This has more than covered a rise in overheads and adjusted operating profit increased by 590 basis points against a very poor result in the first half of last year. Fluid Systems has a more balanced spread across the three elements of Oil and Gas. Improvements in Upstream and Downstream were offset by a decline in Midstream. Upstream was supported by Eastern Europe, Downstream by North America and the Far East. Industrial revenue growth was greatest in Europe, with small changes across all other markets.
This has been supported by one of the site improvement plans, focusing on deliveries of one of our key process actuators. On an OCC basis, order intake in gears was up 4.2% and underlying revenue increased 6.1%. Gross margin increased 80 basis points, reflecting a return to more normal levels compared with the first half of last year, which was impacted by Mastergear integration costs. Adjusted operating margin increased 340 basis points as a reduction in overheads combined with the volume improvement dropped to the bottom line. All end markets were positive with the exception of oil and gas, which was only slightly lower. All geographies grew, apart from Europe, where midstream showed the largest decline. Instruments order intake increased 5.4% on an OCC basis, whilst revenue increased 14.9%. Underlying gross margin increased 100 basis points, largely benefiting from operational gearing. Adjusted operating margin also improved, up 130 basis points.
The strongest growth in percentage terms was in industrial, which was highest in the Far East and Europe. Oil and gas grew by the highest value and was broad-based with only the Middle East declining. The Middle East was the only region not to show growth compared with the first half of 2017. Rotork Site Services remains key to our growth strategy, and our investment to build on this differentiated offering continues. The business is embedded in each of the divisions, but predominantly in controls and Fluid Systems. In March, we talked of investing more to grow our service presence and an intention to add 60 service engineers in 2018. During the first half, we've recruited 26 of these and are on track to complete the recruitment in the second half whilst maintaining high utilization levels.
The number of actuators under some form of maintenance contract is now nearly 185,000 units. In addition to adding to the total number, we are now in the renewal phase of the initial multi-year Client Support Program contracts, and it's pleasing to see customers renewing these early contracts, demonstrating they see value in this arrangement. Our Intelligent Asset Management capability is now under trial at several customer sites to evaluate the offering and develop the analytics further. The advantages of our global presence provide and the part Site Services plays in this area are one of the themes coming through our growth acceleration plan work. I'll now hand back to Kevin, who'll say more about this in a moment.
Thank you, Jonathan. I'd like to reflect on some of my initial observations during my first six months. I've now had the pleasure to travel to many sites, completing tours of our facilities throughout North America, Europe, Asia, and the Middle East. As I've toured Rotork, I've witnessed a real dedication of the entire Rotork team and a strong desire and willingness to engage at all levels of the company to actively drive improvements. My personal observations are supplemented by direct feedback provided to me as I've engaged many of our top and key customers, and by nearly 200 interviews conducted with end users, channel partners, and members of the Rotork community in conjunction with our innovation and route to market work streams. Along with these interviews, we've conducted our first Net Promoter Score assessment, which provided feedback in three areas.
Firstly, we scored extremely positively in respect to our core products, specifically related to our brand strength and recognition, our technology, and our overall product reliability and quality. Secondly, we scored very well in the area of field services. This was noted as a key differentiator for Rotork, and one we expect to expand further as we continue our migration from a traditional reactive service model to a proactive preventative maintenance model, and ultimately to the utilization of real-time data analytics in order to predict failures and prevent them from occurring in the first place. Lastly, the more difficult news was a less than acceptable score in commercial excellence. Whilst it was noted we had strong breadth, depth, and connectivity within our sales team, there were three areas singled out that we can do better, that we must do better. These were quote turnaround times, on-time delivery, and client communications.
We immediately formed initiatives within our existing work streams to target rapid improvement in each of these areas. Turning to our core business processes, I've seen a real mixed bag. We have some strong processes, as well as a few outdated or overly cumbersome processes. We've hired our first dedicated leader of core process improvement to map out our internal processes and to drive simplification, automation, and overall process improvements. As I've now visited many facilities around the world, I have the firm belief that we have abundant operational improvement opportunities. As such, we have rapidly improved our operational bench strength and will spend the next 12 to 18 months driving operational improvements within our facilities. We'll do this prior to engaging in consolidation of any of our mid-size or larger facilities. Let me give you a couple of examples of what we've already accomplished.
The first example lies within our India operations. We've hired new operations and supply chain leadership within India. They, along with other members of the existing manufacturing team, quickly applied lean manufacturing and one-piece flow techniques, resulting in our newest actuator production line having greater capacity and first pass yield than the combined three lines that they replaced. Within our Bath facility, we applied mixed model lean techniques and created our first one-piece flow line for our flagship IQ3 actuators. Our revised production process pulls single actuators through an 8-stage assembly process at a frequency matched to customer demand. The line has been performing well and is delivering a sustained efficiency improvement, as measured by reduction in labor hours per actuator of over 22%, and also accompanying an improvement in our first pass yield.
Within this Bath facility, the revised production line, coupled with other targeted improvements, has reduced our lead time for our standard products by over four weeks since the beginning of the year. Our lead times are now well within customer expectations. Within our stated work streams, individual initiatives have been divided into sand, pebbles, and boulders, classifications depicting the dimensions of both complexity and impact for each initiative. We've identified many pebble and sand initiatives, enough to keep our operating team busy for the next 12 to 18 months. We'll come back and talk to you more about the boulders after we've executed upon our near-term improvement opportunities. These smaller and mid-size initiatives will yield strong results in terms of both growth and margin improvement. They represent lower risk projects that don't require a wholesale shift in the company in order to be successful.
These sand and pebble initiatives will be driven in parallel to our overall IT systems implementations and our continued focus on improvement of core business processes. It is this combination of core business process improvements and systems implementations that will enable a second phase of operational integrations and back-office leverage in the future. Let's take a look at our work stream progress. The overriding themes for our work streams continue to include re-engaging, reinvesting in, and restoring our customer focus and intimacy, driving operational and supply chain efficiencies, improving our core processes and focus within our innovation and new product development efforts, a renewed emphasis on headcount productivity, and a critical review of our strategy, our portfolio, and our current product lines. Our analysis phase began as five initial work streams.
These findings are now realigned within four pillars and are comprised of 12 separate and distinct initiatives and an underlying set of broader portfolio assessments. Each of these having a role in driving the growth and margin enhancement we aspire to. These pillars are defined as commercial excellence, operational excellence, talent acquisition and development, and IT and core business processes. One thing I'd like to make clear, we are not embarking on a big bang, wholesale change. Rather, a series of incremental improvements upon a strong foundation through people, processes, and systems deployment. I'll take this opportunity to reinforce our commitment to a very transparent approach to communicating our ongoing work stream progress. We will continue to provide clarity as to the development and underlying earnings, spelling out our costs and benefits arising from our activities, both planned and actual.
Let's take a closer look at our progress to date and our second half initiatives within each of these pillars. We'll begin with our commercial excellence initiatives. Perhaps our biggest recognition is the need to migrate from a product-based organization to an organization more closely aligned around targeted market segments. Here, team members will be tasked with bringing forward broader solutions to our customers' needs, irrespective of the historical product division responsible for the product. It's no surprise our fastest-growing markets have already oriented themselves in this manner. We will begin a larger phased approach region by region later this year with the expectations that we'll complete this phase in by the end of 2019. The approach will be supplemented by an increasing focus on key account management, end-user engagement, and a renewed concentration on becoming easier to do business with.
Within the year, we've added three additional key account managers, bringing our total to eight team members. The team now focuses on 15 of our largest oil and gas end users and the most active international engineering contractors. This key account team has been able to adapt to the end user's business requirements and to improve relationships with key influencers and decision-makers within the procurement, operations, and project departments. After diving into our processes and structure for innovation and new product development, we quickly developed a revised framework for analyzing and assessing in-flight new product development efforts, as well as those within our individual division funnels. Further, we've completed an assessment of our current engineering competencies and a gap analysis to those required for our future success. We've identified a plan to strengthen those required competencies through building, partnering, or acquiring them where we've identified these gaps.
It's my contention, at least initially, we don't need to increase our spending in innovation and R&D beyond our current 2018 plan levels. Rather, we need to first improve our process and project selection, accelerate our process cycle times, and improve our hit rate through better voice of customer input earlier on in the process. In summary, we need to spend the same amount, but we need to spend it better. Moving on to operational excellence. We began the year utilizing third-party consultants to assist in the assessment of our operations and the identification and program management of targeted improvement activities within two of our larger facilities, namely Bath and Lucca. Since that time, we've added our own experienced and dedicated operational process improvement and supply chain experts, some of whom I've worked with in the past.
As we enter the second half of the year, we are now driving both the assessments and the program management with only limited support from third parties. In relation to our footprint optimization, you can think of this in 2 waves. The first wave is comprised of the no-brainers. These are the small locations with high infrastructure costs that will always be highly dilutive to our margin ambitions. Each of these are being evaluated. We will act upon these more quickly. Meanwhile, within our mid-size and larger facilities, we are emphasizing a program of site improvements through the rapid adoption of lean manufacturing processes. Only then can we assess our real capacity requirements and determine which of these mid-size and larger facilities are candidates for consolidation.
As previously stated, each of these consolidations will be evaluated on a risk-adjusted return basis with a desire to average a payback period of less than two years. In the second quarter, we also formalized our global supply chain organization and began attacking our wave 1 or our test wave of savings categories. These categories included travel, insurance, and some electronics components. Our results have been encouraging, with each of these categories providing a net savings ranging between 5%-8%. We've been actively staffing our new procurement organization, and I'm pleased to say in the last 90 days, we've recruited our global director of procurement and our first 4 category managers. Our second-half focus will be in the deployment of our Rotork lean model with targeted improvements at nine of our manufacturing facilities. These facilities represent over 70% of our overall factory output.
We'll also continue the rapid deployment of our global procurement organization on our wave 2 spending categories. Moving on to our key enablers. Our next two pillars are critical to the achievement of our aspirations. After completing our development assessments of a cross-section of senior leaders throughout Rotork, we have a clear understanding of our needed areas for development. Delivering this development suite, coupled with a realignment between our strategy, behavior, results, and reward systems, will yield immediate results in driving towards our ambitions. As you would expect, we have also been supplementing our leadership ranks with talent brought in from the outside, quickly filling any gaps in our required skill sets. As for our IT and core business processes, we've extensively mapped out our current business processes as well as our desired future state.
We have confirmed our choice of IT platform, and we will be working closely with our technology partners to ensure our platform choice provides the fullest capabilities. We will begin utilizing an enterprise-wide data platform to provide enhanced business intelligence to aid in our decision-making. This will include launching standardized KPIs throughout Rotork with drill-downs to identify root causes of failures. The process will also serve as our internal platform for best practice sharing. Lastly, these pillars are supported by our strategy, portfolio, and product line assessment activities. The initial assessment of our portfolio yielded three determinations of businesses we should exit at once: the nuclear island actuation business, the valve adaptation business, and a small regional engineering center. These businesses account for around 1% of group revenue, and with overheads of circa GBP 5 million, are highly dilutive to group margins.
The payback on these exits will be less than one year. Additionally, we initiated a detailed product line review identifying a number of product lines, which will be withdrawn from production over the next 18 months. These often have lower sales volumes or highly dilutive margins, and they drive a tremendous amount of business complexity for us. Sales of most of these products will be transferred to alternatives, in most cases, to newer generations within the core product portfolio. We will continue to review our remaining businesses and seek additional opportunities for the simplification of our business and the exiting of any non-core elements within our portfolio. I'll close out by making a few comments on the outlook for the year. During the first half of the year, we saw a continuation of the more favorable market trends that were noted in the final quarter of 2017.
We have made significant progress on our work streams, having completed the data capture and analysis phase, and we are now shifting into the execution phase of our growth acceleration program. To support this execution phase, we've initiated an investment program consisting of expansion of our services infrastructure, development of our operational and procurement expertise, and accelerated investment in IT and systems. Spend in these areas will continue to increase throughout the year. Management expectations for organic constant currency growth are unchanged. We expect revenues for the full year to show high single-digit growth over last year on a reported basis, with currency headwinds reduced to circa 3% at current exchange rates. We continue to expect adjusted operating margins to be slightly ahead of prior year. as I indicated on the outset, it's been a very exciting and productive first six months. I'm truly thrilled to be leading Rotork.
We have a lot to do, and our team is truly up for the task. With that, Jonathan and I would be delighted to take questions you may have.
Zander has a microphone that he'll bring around.
Good morning. Michael Sherlock from Investec. I think at the outset of the review of operations and processes, we're given the impression that the rate of progress, the rate of spend, would depend on the rate at which cost savings could be found. In other words, the investment would be funded out of savings. Is that still broadly the expectation, or are you accelerating?
That's still the expectation. I think, as we said originally, the spend and the return is not going to match perfectly period on period. It's still that view of over a two-year period, The aim is to cover that in that timeframe after investment. Obviously, lots of different projects are happening at different times through this year and will likely through the rest of the period.
Does that include the expenditure which is treated as exceptional?
Yes. That's the spend we're referring to, really.
Yeah. Okay. Thank you.
Thank you. Mark Davies [Jones] [inaudible] Stifel. If I can go back to the broad outlines of the plan, Kevin. I was just slightly surprised by the suggestion that R&D didn't need to rise, and actually, what you set out sounded more like an efficiency program and a series of consolidations than a growth acceleration program. Could you focus more on the growth side of this in terms of what's changing? Clearly, the solutions and service focus is part of that, but more focus on the growth end of the story.
If we think about the growth end, the first and foremost piece is the one boulder that we're taking on right now, which is the route to market change. A lot of our work and research by the third parties have brought to mind that as we're going to market in individual product divisions, we're limiting the breadth that we're taking to solve customer problems within these end-user segments. By reorienting the sales force, and this is really more related to the end sales force, into focused market segments, we'll be able to bring a broader portfolio of products to solve problems for our customers. That's one of the biggest things that'll drive growth in that we'll bring actuators coupled with instruments to increase our average ticket price, for example, in a particular installation, right?
Whereas previously, you would have an instrument salesperson going perhaps, or in some cases, the controls or an RFS. We'll be able to combine and be able to provide those broader solutions to customers when we have those individual sales opportunities. Relative to your question on new product development, if you think about what I look for in new product development, the first assessment was that our spend of currently about 1.7% on innovation and new product development. When we look at what we're spending overall in engineering, that's only a piece of our overall engineering spend. We spend 1.7% on innovation and NPD, but we have a large grouping of other engineers that are application engineers, for example, within the business. If you really look at our total spend in broader engineering, it's over 3%.
It's a much bigger bucket that we can improve upon. Within that, we think we can use some automation in systems and tools to improve the application engineering portion and redeploy some of those engineers back into new product development. Secondly, when I looked at the efficiencies of our new product development and the scale of the programs we're undertaking, I was underwhelmed. We can certainly take on some bigger programs, put more focused teams on those programs that include dedicated marketing and product management resources, and certainly some better voice of customer resources to ensure that we're doing some bigger innovation and new product development initiatives more closely aligned to our true customers' needs. I think that's an area that we're going to focus on pretty heavily. The other observation is that we're spending new product development GBP almost as an entitlement within each division.
Each division has a particular percentage that they get to spend, and we're not doing that from a mindset of overall, is this the right spend for Rotork? Obviously, spend that we would put in our controls or our electronic actuator platform yield a much, much higher return than they would down at a gears platform. Yet, because gears has the need to spend that particular percentage, they will continue to go down the product line of developing lots of little small singles at best. Where I want to take that spend and look at it overall at Rotork and say: How do we spend those GBP most efficiently and gain the most revenue and margin from that spend? Just a few tweaks of how we're looking at things a little differently. Those individual division engineering leaders are now combined into one global engineering team at Rotork.
We're looking for that leader of that team now who will help us elevate this and spend it much more effectively from a group level. It gives you a sense a little bit about that.
Hi, it's Andrew at Barclays. Just to follow up on the new product development on the R&D spend.
You said it would be sort of the 2018 level would be sensible going forward. Is that an absolute number or is it percentage of sales? Secondly, it does sound like the R&D plan has changed a little bit. Is that something that you've done, you've come in, seen what was being worked on before and said that we need to change direction?
Yes.
Thirdly, totally different question. On the second quarter orders, growth was, I think, pretty much flat. Could you just talk a little bit about the market there and was it purely the comp or something else happened? Thank you.
You want to address that?
Let me do that one first. Second quarter of 2017 was the strongest quarter in that year by quite some margin. We knew when we had our first quarter update in April that the comps got massively tougher as we got into the second quarter. The fact that we did slightly exceed those in terms of order intake with Q2 this year was a good result. Do you want to pick up the other pieces?
Yeah, absolutely. Let's start with the second point. The answer is yes, that was something I came in and looked at pretty heavily. New Product Development is critical to the vitality of any organization. When I came in and evaluated, first issue was I had to evaluate division by division, which was my first problem, that we didn't have a central database of all our ongoing activities. As such, there are certain core elements to product development that we were working on kind of simultaneously in two different divisions. A simple example would be battery backup technology. Key innovation is to be able to continue to operate an actuator without power. We had battery technology being developed within one division, and then as I went to another site down the road and looked at some of their new developments, guess what?
We're developing a new battery backup technology. The fact that we weren't coordinating our New Product Development efforts at the group level was an issue, and we were replicating efforts and spend in developing two different platforms of backup technology. That's just one quick, simple example of an observation. The first thing we did was pull every ongoing project into one database. We looked together at what that spend is, the amount of man-hours dedicated to each one, the first, third, five-year sales and margin attributable to those products. Then we began to look and deeply analyze what we're spending on currently. We found that probably as much as 20%-25% of the active projects I would kill, frankly. Not strong enough projects for us to take forward, which would, again, free up more resources to work on some bigger hitting, bigger moving pieces.
That's really part of what we're doing. The second thing we're doing is each individual division has developed its own New Product Development Process, with different varying levels of whether they're really sticking to or adhering to some of the core process elements, such as robust voice of customer up in the up front. We've harmonized those into one Rotork New Product Development Process that involves some critical steps such as manufacturing engineering in the process, to ensure that we're creating the most modular pieces of our business. I think we've given you examples before of when we develop products, we often focus on the unit cost, and as such, miss the fact that we could be much more modular. Great example we gave, I think, last time was in our housings for our actuators. The housings come in, I think about three frame sizes.
We don't really have small, so it's kind of medium, large, and extra large frame sizes. In each one of those frame sizes, you have one, two, three, or four inlets. Right there, you're carrying 12 different components you have to stock in inventory the way we're currently designed. Why we did that was that to drill that extra hole was an additional one and a half GBP. They'll look for that. The reality is that one and a half GBP, over the course of how much inventory and the complexity that drove of now keeping 12 of those bodies in, when for GBP 0.50, we could plug that hole, only stock fully machined four hole, and then reduce down from 12 stocking components to three through manufacturing engineering. That's some stuff that has been lost on us for some time.
We're actively focused on several buckets of engineering. We're increasing our focus on manufacturing engineering to increase the modularity of our existing product lines, we've rededicated handfuls of resources into those efforts. We're certainly focused on the innovation, taking from the blue sky ideas of innovation down to seven targeted products that utilize our core innovation technologies. We're focused now on seven products to get them done. Again, platforming from those big ideas into execution and let's get seven products in flight that we really think can move the needle for us. Then staffing those teams much more broadly than we've done in the past. In the past, the cycle times are so long. Because we'll divide it up into so many projects.
We only have a couple of engineers working on each one. Our average cycle time is far too long. I've been running engineered products companies now for the better part of 20 years, and I can tell you that cycle times of two and a half years to launch new products, quite often the market's changing during that time period, and you may miss the mark in the end. We have to accelerate that to a much more acceptable year and a quarter timeframe. That's some of the work we're doing in new product development. Hopefully, that helps you.
Sorry, just the R&D spend question.
Yep.
Is it an absolute number, or the percentage of sales that'll be helping them?
I think I made the comment initially to hold it at 2018 because I think it's really going to be determined by what opportunities we really see as we continue to focus and engage end user customers, create that voice of customer. If, in fact, we see substantial new product development opportunities that cause us to increase that spend, of course, we would do that, mindful of the payback, and we may, in fact, increase that again in the future. For now, only this year I'm saying we're going to hold and we're going to execute much better. Yeah.
Hi, good morning. Alasdair Leslie from Societe Generale. Just in the release you talk about innovation, I follow on to the last question, just identifying gaps in competencies.
Just wondering if you could talk a little bit more about that in terms of, I suppose, the context of [inaudible] in the portfolio and then the balance between partnering and doing that organically yourself and maybe through acquisitions as well, just the expectations there. Then a follow-on on, I think a year or so ago, you kind of identified, not you personally- but your predecessor identified a sort of a strategy to push into industrial automation for the instruments division, seemed to be quite strong growth-
in industrial process markets, in H1. I just wonder whether, A, that strategy is still something you're going to pursue quite aggressively, and indeed whether you're already sort of seeing the benefits from that in terms of market share gains. Thanks.
Let me take the second half of the question first, we'll get back to the engineering competencies. One of the fundamental reasons why we want to alter our route to market is to address the fact that we have markets such as the industrial process markets that are growing much, much faster than some of our other cores, additional focus there will lower our reliance on oil and gas, obviously, right? If you can imagine an individual salesperson who's tasked with selling everything in a given product portfolio, who's not oriented around a particular market segment, they're given a choice to come to work every day, they're either going to sell an IQ3 actuator with the most dominant brand, thousands of GBP per unit. It's just much easier to sell that than to go sell instruments that are GBP 90, GBP 100, GBP 200, right?
The fact that we haven't segregated our sales force and said, "This group is focused on driving the instruments business. This group is focused on downstream oil and gas actuation." That's one of our issues we're trying to solve for, because we do think that that business has probably our fastest, biggest growth opportunity as we go forward. That's part of the reorientation, is to make sure we have dedicated focus resources going after the process industries. Okay? Relative to the engineering competencies, if you would imagine visual with me of you have kind of the current competency and its area of development, meaning high, medium, low on one axis. On the other axis, you have the requirement of that competency in the future. Rotork, we have a lot of really great mechanical engineers. We have a lot of really great electronics engineers.
If you think about where we're heading as we go forward, much more software, much more data analytics would be kind of the two easiest examples for me to give you. In recognizing that certainly in support of our iAM program, we need much more capabilities to analyze data, package that data, and give it back up to our customers. We recognize that we need help in that area, both in terms of data security and in terms of, again, making that data digestible for our customers. We've partnered, in that case, with an outside institute that focuses on data analytics, and we're bringing them in. They'll be working with us between now and the end of the year to help solve that piece of us, right? At the same time, we are hiring a data analytics engineer internally to help us.
We're going to supplement that with some outside resource because we really think that our AM program is very, very strong. The early trials are very encouraging. We need to accelerate that competency development far beyond where we are today. Okay? Easy example. Yeah.
Hi, it's Jack O'Brien from Goldman Sachs. Just want to think about the market growth you're seeing and expecting at the moment. In oil and gas, obviously, there's been a bit of a catch-up in terms of MRO spend. Do you think we're now at a normalized level going forward, or is there still some pent-up demand from MRO and lack of investments over the last couple of years?
Really hard to say. Certainly, as far as the first quarter was concerned, it felt like there was an element of catch-up through that period, and that was one of the things that contributed to the strong quarter, as well as some return of some big projects. We haven't seen the big projects in the same way in the second quarter, that's one of the reasons the second quarter is lower than the first on a sequential basis. I think that MRO, that kind of small-scale plant refresh upgrade stuff, that's still going on. It's just very hard to judge whether that's a new norm, an element of catch-up. It's not really easy to distinguish in those ways.
I could comment on that from some of my personal customer interviews. What we're seeing for the first time in a long time, this was in the Middle East in talking with some of our critical customers in Saudi. They now have, for the first time in a long time, budgets, for example, to replace a third of their actuator population this year, a third next year, and a third the year after. It's a significant trend that they're communicating that's going to go on for several years to come. That's just from one of the direct largest oil and gas companies in Saudi.
When you look across the different regions, do you see a difference in sort of propensity to maintain installed base? Obviously, Middle East sounds like there's a bit of a catch-up going on.
Elsewhere, is the U.S. or Asia, are there regional differences you see?
I don't think there's regional difference. Obviously, there is differences in terms of where the focus of spend is. In the Far East, certainly in the first half, it's been more about downstream and new capacity than it has been.
MRO or upgrade, small project stuff. It does vary by region just as our sales vary by region in terms of the degree to which they're oil and gas focused.
Okay
for example.
Perhaps just one more on the market before a service question.
Yeah.
Feels like midstream still fairly muted market, I guess LNG pipeline, not much going on there. Is that a flat market, you think?
It has been in the last 12 months or so. Obviously, prior to that, we had a big high level of LNG, and there's certainly talk in terms of return of LNG sales at some point in the coming years. I think some of it driven by marine fuel changes, switches to LNG and increased capacity required potentially for that. Some of it simply driven by where the LNG reserves are and where they're likely to be utilized. I think LNG will cycle back in. That tends to be the nature of that part of midstream. I think in terms of the pipeline spend in midstream, we've not seen any major pipelines. I think there are, in terms of the scale of some of the ones we saw in China a few years ago, but there is still an active pipeline market at a smaller scale.
Certainly in the U.S., Canada, we've seen some pipeline projects proceeding. The midstream peaks and troughs tend to be driven more by the LNG than the pipes.
Okay.
I think just, again, to give you some specific customer color on the midstream. While I visited China and spent time with many of our customers, I spent probably two full days with China National Petroleum Corporation, one of obviously the largest. One of the visits was to their midstream pipeline group, where they displayed for me all the ongoing plans for the next three years. I think it's pretty significant beginning in 2020 and beyond. I think 2019 is still planning. If you think of the area of consumption, the fastest-growing consumption of energy products in China, and the demand coming from Turkmenistan and certainly other areas, there is an absolute recognition that China will run out of gas within this strategic time frame of three to five years in terms of the overall supply.
There are lots of plans I was able to view and have discussions of and formulate partnerships in fact, to participate in those projects. I think it's an exciting time, not this year, not next year, but beginning in 2020, I think we'll see a pretty substantial rebound in the midstream, I think.
Again, just one final question on service potential.
I think you mentioned 185,000 actuators with some sort of service contract. Today, when you sell an actuator package, what proportion would have some sort of service contract alongside it in percentage terms?
In terms of bundled with the actuator, it's going to be a very low proportion because of our sales channel process. On the larger projects selling to the valve maker.
We aren't going to be able to bundle a service contract with that. If we've got the relationship with the end user that's driven the purchase via the valve maker, then clearly we have that good chance of getting back in once the site's up and commissioned and running to then engage and sell the service proposition. That relationship sort of starts before we deliver the actuators and picks up again once they're installed. Tying the two together as part of a contractual sale is not that common an event.
David, I have for you a couple, please. In terms of your sand, is it gravel and boulders?
Sand, pebbles, and boulders.
Pebbles and boulders.
Obviously, the boulders are the big ones. Presumably, they can have the most impact.
It sounds as though those are going to be delayed till 2020 or 2021. Is that fair? You've obviously had a lot of internal reviewing. What are your views of the portfolio now you've been there for six months or so? Are you ready for looking at acquisitions now, or do you think you want to get the home sorted out before you start looking afield?
Let me take the first part, the boulders, pebbles, and sand. The larger boulders would be the very high, complex, large facility integrations. Frankly, the assessment is that we're not ready to do those yet, for a couple of reasons. One, I think we need to develop a stronger execution capability on those big, complex moves. We need to start with some of the smaller, easier ones and develop our process and hone that process a little bit better. Secondly, one of the key enablers for that is our IT implementations, to be able to get on to similar platforms and similar systems. Until such time as we're able to migrate two sites on a similar platform, trying to do that and integrate two new systems into a site at the same time, I think really increases the risk for us.
I don't think that's really our right approach. It's a focus on getting on the right systems platform. While that's happening, in parallel, we're going to be working on those sender sites, if you will. We will have the senders and receivers. Those sender sites are going to have focused efforts to improve bills of materials accuracies, for example, to focus on their supply chain. What we're moving is really in much better shape prior to uplifting it and moving it, and it'll be on the same systems, which will increase our opportunity for success when we start doing some of the more complex integrations that we do have in mind for the future.
The real boulder we're taking on now is really that realignment of the front end, if you will. We're going to do that in a very phased and measured approach over the next 18 months versus slam it through. We're going to do it region by region within each of those regions. The first region we'll be utilizing as a pilot to ensure that we've got all the intercommunication and connectivity points between that orientation of the front end, all the way through new product development, all the way through financial reporting, all of the above. We want to make sure we're taking a very measured approach. Then relative to acquisitions, again, an early assessment looked at our acquisitions, and we currently have four individuals responsible for business development and M&A residing within the four divisions.
I want to elevate that. We're actively searching now for our new head of strategy and M&A that'll help us pull the broader Rotork strategy and ensure that the acquisitions, that in the future will be larger than some of those really small, tiny bolt-ons that again, added to our complexity so much in the past, are really meaningful to the broad Rotork portfolio and fit into our strategy as we go forward. Right now, I wouldn't say we're at a pause, but there's certainly a higher threshold of approval prior to deciding in the middle of all this other work, we're going to go and pivot and do something in the near term, right? We'll still be opportunistic in the next six months.
If the right thing crosses our desk and hits our financial metrics and we say this is so hard to pass up, we'll allocate resources and deal with it as they come up. I'm much more focused around developing a much more proactive acquisition strategy that in advance identifies potential targets, begins to cultivate them more on a proprietary basis, and leads to an improved hit rate as we go forward.
Morning, Kevin and Jonathan. It's Ed from Citi. I just had a question on the energy markets. To the extent that you are seeing projects coming through, are these projects that were quoted for before and therefore might be on a more competitive [inaudible] rack, or are they completely new projects?
Well, obviously, we've mentioned two projects that are coming out through the controls division revenue in the first half that are at keener margins than sometimes. I wouldn't say those are necessarily a function so much of when they were quoted as a function of the size of the project, and that's often the case with some of those larger projects. I think we're not seeing stuff coming through that was quoted multiple years ago as an initial point when the market was particularly tough. There's not that sort of element of order flow still to come. No influence from that.
Right. On water and power, which were-
Yeah
down on a revenue basis, any worry there or is it
I don't think we anticipated power being strong this year. Of all of our end markets, that's probably the one that is least active. I think the reduction in water was, I would say, was more of a surprise possibly than the power, driven largely by a sort of slightly, a bit of a pause in the U.S. municipality market, which is one of our biggest water markets. They've just not been progressing with spend at this point, I think while they work out what the environmental requirements may be in the future.
Okay.
Hi, it's Andy Wilson, JP Morgan. Just a few actually on the strategy. Can you just give us a sense of where the biggest surprises you found in the six months that you've been here, against what you obviously initially expected? Also just if you think there's more or less that needs changing than when you came in.
Hmm. It's a great question. I would say that the two biggest areas where I found more opportunity than I expected, frankly, would be in our manufacturing operations and our new product development. Those are certainly two areas that I see a lot of room for, a lot of opportunity for improvement and efficiency gains.
In terms of the overall picture of how much needs doing, do you think there's more in a way, and I guess you can spin this positive or negative, right? There's either more that needs doing, and that's a problem, or there's more opportunity.
Yeah.
Is it more or less, if you sat back from this and thought, "Actually, there's more to go for here?" The reason I ask is
I think there's more opportunity than I expected, which for me as an incoming CEO is exciting, frankly. More importantly, the opportunity are things that I've had the experience of doing time and time again. When I think about the supply chain, the operations and new product development as three of the critical areas where we can truly improve, those are three areas where I have a lot of experience and frankly, have a pretty good network of people that have been there and done that to bring in to help. When we've talked about adding some of the resources that I've worked with in the past, we're very quickly able to deploy some resources that have had those same experiences to quickly drive traction and bring in, for lack of a better word, a pretty well-defined playbook to bring to bear at some of this.
That's certainly true in the operations, procurement, and supply, and engineering.
The reason I ask is if we go through all the things that you're trying to do, and I appreciate it's staggered and some of the smaller stuff's been approached first-
Yeah
It feels like there is an awful lot you're trying to do all at once-
In a market which, because of what's happening in terms of demand, as you obviously these ones are going to be picking up all the time. Is it this kind of previous experience that gives you a sense actually this is achievable or is it-
It is.
Yeah. Okay.
Yeah, it is.
Thanks.
Yeah.
Good morning. Hi, it's Jonathan from Deutsche Bank. Just following on to Andy's question, just coming back to the sort of the timeline of implementation. I know obviously the projects have started, and it's a bit of a moving feast, but when do you think or what date do you think would have executed most of the savings or most of the actions within the business? Is it a three-year, five-year type horizon?
The savings are in two tranches, if you will. The sand and pebble stuff will certainly be in the next 12 to 18 months. Some of the bigger integration efforts, and back office leverage will come after we've implemented systems. If you think about the incremental new product development, the supply chain, all those things we're going to get after pretty quickly, and I think we'll see savings next year and certainly thereafter in some of those smaller quick-hit initiatives. The next big phase will be when we get to common systems that will enable us to get a different scale of operating leverage. A couple of examples. In North America, I do order entry in eight different locations currently. That's in pretty much one language. I don't need to be doing order entry in eight different locations.
I need to consolidate into one larger regional customer service center. I can't get there now because right now I'm using 6 different IT platforms between those 8 locations. When I get the IT platform in place over the next 2 years, that enables a whole other level of back office leverage and back office integration. That's one example, but you could repeat that example through Asia, through Europe. There's just a lot to gain in that second wave. However, we've said, "Well, we're not going to sit here and spend now on the IT and then wait for that to pay back." These other initiatives are what'll help us fund that along the way. There's plenty to be done.
Frankly, the assessment coming in is we have a lot that we can do here in the next 12-18 months to drive this margin while we wait for that second phase of integration. That's how we're modeling it out, if that makes sense.
Just coming back to that later, sand, pebbles versus boulders. Just come back to what David asked. In terms of the magnitude of the savings, boulders versus sand and pebbles, what's the kind of ratio would you expect?
The sand and pebbles, sand is typically kind of one percenters, one and two percenters, small movements. The boulders are saying that those are things that are going to accomplish five percentage points of our overall aspiration. If you think about the margin improvement we want to make, you set that bucket of money aside and you say how we've classified them is if it's a bigger than 5% of that bucket, it goes into the boulders. If it's 3-5, it goes into the pebbles, and if it's the 1-3, it goes into the sand. That should help you frame out some of the pieces.
I think in terms of the pebbles, it's really about some of the generational new product development, supply chain, increasing our service pieces, the modularity, sustaining engineering, all those things are things that are certainly medium complexity, but they'll all yield some pretty nice things for us. In terms of the sand, it's some of our rapid commercialization, some of our quick-hit improved customer communications, fixing lead times, the SKU reductions that we're getting after that'll have a positive impact on our business. We've taken a lot of our initiatives and broken them up into those buckets, and we have a pretty good understanding of the timing of each of them and the complexity and the returns. The boulders, again, the only boulder we're really attacking early on is the route to market.
The others are those large facility consolidations, I would say that next generational innovation stuff that'll take longer. It's more of a complexity and timeline on some of those longer-term innovation things.
Hi, this is Sandeep Gandhi from Exane BNP Paribas. Last time, your predecessor talked about getting margins up to 25% in the medium term. Based on what you've seen during your time here, is this still a realistic target? Over what timeframe would you expect this to happen, if so?
We continue to think of this as a 3- to 5-year journey. Yes, it's very realistic to get to those margins. Absolutely.
Just secondly, on the order book, can you just give us a sense of the lead times for the orders that reside in that order book? How much of that is likely to be shipped in 2018 and 2019? Thanks.
The vast majority of the order book would be expected to go out this year, somewhere sort of 85%-90% of it. The ones that are there a half year, which is normal. The lead time of the stuff within there varies from 48 hours through to 16-20 weeks. Partly around the divisions and obviously the complexity of what's being supplied. Fluid Systems tends to be the longest lead times, instruments typically the shorter. There is that broad range within that GBP 200-plus million order book.
Thanks.
Good morning. Dominic Conway from Peel Hunt. Just a couple of questions I made, again, around the themes of the big plan. I guess given the sand, pebbles, and boulders analogy, and maybe the subtle shift in the R&D strategy, it feels as though we are seeing perhaps a slightly different curve for the margin profile over the next three to five years, albeit with the same end target. Is that fair? You said slightly ahead this year on last, so that seems reasonable, but it feels as though it's going to be a little bit of a more shallow progression the next two or three years and then kicking in back end.
I think we're clear on where we are this year. I think we've not really given a steer as to the profile of that curve between now and five years' time, three to five years' time. I think we've said you're not going to be waiting right till the end and see a big hockey stick. It is going to be a number of initiatives that are starting now are going to start to deliver savings. The procurement is an example of an area which the team's now largely established. They know what they've got to work on next in wave 2. Some of those things come through relatively quickly in the sort of timeframe we're talking about. Some of those things will start to feed through as we get through years two and three.
Picking up on the overall themes, there definitely does seem more of an emphasis on efficiencies in the near term rather than necessarily the growth acceleration. I think the question, I guess, is does that focus on efficiency extend to the balance sheet? I'm thinking in terms of things like working capital, 29% of sales. Is that best in class, or do you think there's substantially more to come out of that? Then I guess with the de-emphasis perhaps on M&A, albeit opportunistic still, would you think is the balance sheet right in your view, Kevin, for a business of this type, or perhaps should there be a little bit more leverage on that?
Well, it's a lot of questions put together. Again, relative to the themes, if you think about working capital and in particular inventory improvement, that's one of the areas where I've come in and looked at the business and I think my predecessors looked at the business and weren't satisfied with our inventory turns, right? For a business our size to have inventory turns in the sub three, that's really not indicative of what I've been able to achieve in engineered product companies. We're bringing in an entire new training on inventories from one of our operations initiatives. One of those 12 initiatives is a focused initiative on improving working capital, and that has two key components to it.
Obviously, a keen focus on the inventory, and you could do your own modeling in terms of what it means for us to go from sub 3 times to 4 to 5 over the next several years in terms of inventory turns. Then also, to solve for the inverse we have between our receivables and our payables. Again, that'll be driven by our procurement organization as they come in and reset terms with several of our suppliers to begin to change that relationship between the two. That is one of our 12 targeted initiatives on working capital improvement. I think relative to the balance sheet, again, heading to a very low net debt position. I think we're comfortable in my communication with our board to certainly go up to maybe 2 times leverage in the future for the right deals.
I think we need to ensure that they have a very strong return in order to do that and justify that. I wouldn't say that it's a full-blown We're not out of the acquisition game by any stretch of the imagination. We have a lot of work to do in the next 3 to 4 months timeframe first, and we have to find the right resource to help us come in and to twist that into a much more proactive approach for M&A. It wouldn't surprise me if we were sitting here next year at this time and we're effective in doing something, that's just how it goes with M&A, right?
Thank you.
Thanks. Just one follow-up from me on materials and components. You mentioned the material cost inflation. Is there an issue around availability as well and lead times on things like castings?
Not an issue around castings. As obviously with the outsource manufacturing model, we're always managing a whole variety of different commodities, components, and things from the supply base around the world. Typically, there's pieces we have issues with of some degree or other quite a lot of the time. There's no particular dramatic change in that going forward versus what we've seen historically as we stand today.
Would the same apply to electronics?
Electronics at the moment is one of the areas that we are, as you would have seen, was one of the areas we're pointing at to just signing up some new suppliers. It's one of the things that within phase one, we did some new suppliers. It's another focus point for phase two is to continue that work, to make sure we don't have or to manage any issues we might have around electronics.