Rolls-Royce Holdings plc (LON:RR)
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CMD 2018
Jun 15, 2018
Good morning, everybody. And I must say thank you all very much for coming along. This is a fantastic turnout. Shows that there are a lot of people interested in Rolls Royce, so thank you very much. I'm going to start with a few of the sort of boring things probably, like the fact that if there is some alarm, we go out through there and Rolls Royce people will direct us to where we have to stand.
And just to be good if everybody can turn off the noises on their mobile phones, please. Thanks very much. The agenda that we have for you this morning is I'm going to introduce things for a few minutes at the start, and then we're going to have an example of one of our businesses from Andreas. Harry is going to talk about the restructuring that we announced yesterday. Stephen will show how that translates into numbers.
And then I'll make a few comments to close with. So after my introduction, why have we chosen Power Systems? It's an example of one of our businesses that's in transition at the moment. And Andreas will illustrate some of the improvements that we've been making over the last twelve months and we aim to be making over the coming years. The other reason we chose it is because when we discuss things with the financial community generally, we spend about fifty five minutes of every hour talking about Civil Aerospace, and we thought it'd be a good opportunity to talk about part of another part of the business.
Yesterday, we announced a fundamental restructuring. I'm going to talk a little bit more about that in a few moments, and Harry is going to plunge into some depth. Yesterday, the emphasis was very much on the people side of things. And today, we're going to, in the last session with Stephen, talk about how that translates into returns. I hope you'll go away with an impression of why this change that we're making is absolutely fundamental and why it's not just another cost reduction exercise.
However, before we get started on the business of the day, I do know that there's a lot of interest out there in what's happening short term and, in particular, what's happening with our Trent 1,000. So right at the top of the slide, as we said in March and as we said in April, this is a situation which is causing a number of our customers a huge amount of disruption. So we had a team down at IATA in Sydney last week, and they were absolutely flat tack with our airline customers, spending a lot of time reviewing the plans that we have and basically working checking in at a high level on how the close interaction with those airline customers is going in the detail. I think to summarize the situation where we are at the moment, we have completed the first stage of the initial inspections on all the PAC C engines. The good news is that we've sort of gone through the peak of that, and the incidence of aircraft on the ground turned out to be less than we actually feared.
And the incidence of failure on the repeat inspections because we're now into repeat inspections so far is going better than we had anticipated, which is all good news. And we have started a one off inspection of the Pack B engines. There are 166 Pack B engines, and we're going through a one off inspection right now of those to establish some data. It looks like at much, much higher cycles, much, much later in the engine life, there may be a similar issue. And I mean the good news is it's much, much later in the engine life, so it actually happens after scheduled maintenance in the main, but we want to gather some data to get to the bottom of that.
However, the we anticipated a pretty grim situation with aircraft on the ground. And so we told you in March we were going to add lots of capacity to deal with this. The good news is we have added lots of capacity. We've trebled our maintenance capacity. We've reduced the cycle time, the time it takes to go through one of the inspections and to go through replacement of defective parts.
And the bottleneck has now shifted from MRO capacity to logistics. The fact that an airline is based in one part of the world, we have repair and overhaul, which we have spread around the world, but it's still physically removed in many cases by up to a week or so of transport for a very heavy item in both directions. So logistics is probably now the bottleneck on bringing this peak of aircraft on the ground down and for an individual airline to bring the number of aircraft that you have on the ground down. The good news is when we wrote this slide, we were getting on for 50. We never actually hit 50.
And as of last night, we were at 44, and it's starting to decrement pretty daily at the moment. Now there are three stages. First of all, there's inspection, then there's deal with it and then there's fix it. And on the fix it side of the chart, as far as the PAC C compressor rotor blade is concerned, which is what's caused a lot of the concern over recent weeks, We have a new design. It's testing is going well on that new design at the moment.
I saw it last week. And we hope that, therefore, we will be able to pull the fix for that in from Q1 next year into the end of this year. So that's continuing to move on a positive trajectory. We'll then fall back to the limiting factor, which is turbine blade capacity, and we have been addressing that. And since March 7, then we've continued to improve on turbine blade capacity.
And actually, since the beginning of this year, we now have approximately 50% more turbine blade capacity than we had at the start of the year. And so we will, we believe, be able to eat through this problem. What difference does that make to our guidance? Well, the key message here is that our guidance for 2018 is unchanged. We clearly laid out on the March 7 that we expected 2017 costs to approximately double in 2018 and then fall in 2019 and 2020 and so on.
Since the March 7, we've had accelerated inspections on Pack C. We've decided that we want to investigate for data gathering on higher cycle engines on Pack B. But because we had a better aircraft on the ground situation than we anticipated, because our MRO response has actually been at the high end of our expectations, then actually, the good news is that the cost of those incremental pieces are not going to be quite as much as we thought. And so netting out those, we end up at approximately £100,000,000 of additional cash in 2018 compared with where we were on the March 7. And as we said in April, we've taken additional mitigating actions to cover that £100,000,000 and that's a bit of rephasing of some nice to have projects, cuts to discretionary expenditure, and that's how we are maintaining our guidance.
So now I want to get into the business of the day. That's the end of the Trent 1,000 update. Getting into the business of the day. So I put this slide up at our full year results. This was a summary of where we got to with our transformation program announced in 2015.
In 2015, it was obvious that some significant change was needed. We did some change. We completed some of what I called organizational hardware, and we needed to do some organizational software. In March, I reported good news, we've done some of that, but there's a heck of a lot more to go. And today is about that awful lot more change that we need to make in terms of the organizational software.
And what we have discovered is that in order to do that, we need to make some much more fundamental change to what I was previously calling the organizational hardware, I. E, the structure of the organization. So much more radical change is needed to the structure in order to achieve this whole thing and make the obvious change that is necessary for Rolls Royce. So today, it's a pivotal moment. And it's an intentionally big word, pivotal, and I'll come back to it in a moment or two.
Basically, an awful lot of preparation has had to be done, not just over the last few weeks, not just over the last six months since we got AMM in to help us with this, but actually over the last several years. I had a number of questions yesterday from the media about, well, why on earth didn't you announce this three years ago? Because actually, that would have been exceedingly foolhardy to announce that three years ago. We had to get on with stabilizing the business, do some really sort of crucial things, tighten grip on the business and prepare for a big change to do it properly. Things like we did have to stabilize the business.
A crucial question a few years ago was could we deal with a volume ramp up from approximately 300 engines to approximately 600 large engines per year, okay? So that's getting there, well over 500 engines last year, nudging towards 600 this year. We had to bring several new products to market. And actually, over the last three years, four new civil engines have entered into service. Now it's absolutely essential to get these solid foundations in place.
There was some tidying up of the portfolio to do, and we've been addressing that through a combination of some reorganizing and some disposal activity that you've heard about. And last but not least, I had to establish a leadership team that was up to the task and up for the task of leading this company through a fairly pivotal change. And that leadership team has changed significantly over the last couple of years, and you can't do that overnight. So 90% of the executive leadership team has changed, and we now have a mixture, approximately fifty-fifty, of established players promoted and fresh thinking from outside to deal with this task. So that was the answer yesterday.
A summary of what we announced yesterday in terms of facts and figures. Well, we're going for something which is much, much slimmer, leaner, more nimble. Net savings, pounds 400,000,000. Net costs per annum from the 2020, net costs approximately £500,000,000 That will unfortunately involve the loss of about 4,600 jobs. I spent a lot of yesterday explaining that a lot of those jobs will be lost in The U.
K. And consequently, a lot of them will be lost in Derby. They are management and support functions largely. And that is making the big structural changes necessary so that we can really affect a proper culture change, and Harry is going to talk about that in a lot more detail. The idea is to create a world class business that matches our world class technology.
And it's no secret or it's no coincidence that we've got a picture here of our newest engine, one of the Pearl series for business jets that was announced a couple of weeks ago. It was launched a couple of weeks ago. No coincidence we've got that picture there to reflect the newness of the new management system and the new behaviors that are going to be apparent in this business from now on. So what now? Before I go on to what now, sorry, bit of context.
And again, so this is back to why I used the word pivotal. It's important to understand that this is a new phase in the development of the company. This isn't a cost reduction exercise from 2015 to 2020 to achieve some better returns. This is about making an organization that is ready for the next phase of its development. I said in the media yesterday, we've been around for one hundred years.
We want to thrive for another one hundred years, and a fundamental change is required. So at the left hand side of the slide, we've got a period of evolving engine architectures. We've got a period of developing market share. We're now going from the developing market share phase into the using market share phase, where we use that market share to generate returns and invest in new technology going forward. So to put some metrics on that, in fifteen years or so ago, we had about one in seven of the large jet engines flying around.
Today, we have about one in three, and we have an order book that will take us to about one in two in a few years' time. We invented the Total Care product way back before the turn of into the twenty first century, but actually, we had a very small share of that. Now to make this business really work, we need to have an annuity type income. And so what's been developing over that period is the total care packages has evolved from few to most of them. And in fact, when we take orders today, about 99% plus go out with a Total Care package.
And we needed to move from what is essentially a bespoke business, where we made very small volumes of a large number or a number of different varieties of engine to much higher volumes of only a few varieties of engine. We need to move from bespoke to industrial. And also, as I mentioned earlier, double that capacity in just the last three years. So that's the wider context for this change. What What now then?
Our ambition is a much, much simpler business, one which doesn't celebrate complexity but celebrates simplicity. And we've structured the business, we'll talk about in terms of three empowered businesses, and we think that those businesses can deliver materially improved returns as we move into this next phase. We understand on technology that we need to be using the world's best technology, but we can't necessarily own it all. We need to be quite selective in terms of what we own, what we produce, where the key intellectual property is and where this other world class technology that perhaps isn't key property for Rolls Royce, where we need to do some partnering, so that we can be the world's leading industrial technology company. And by world's leading, I mean not just a company that responds to market changes, but a company that actually makes the market change, and that is a market leader.
And Stephen is going to talk a bit later about translating some of this into financial returns, and there are a couple of midterm ambitions here on this slide. And I want you to note that we're talking not just about quantum but about quality as well. It's not just about how much return, but it's return related to input and therefore, a measure of the quality of that return that we're going after. And so what are our resources available? I tell our people that our competitors have access to all the same technology that we do.
They have access to all the same customer base, all the same equipment and so on. The only difference is the people. Well, that's true. The people are the differentiating asset. We have access, of course, to three basic categories of asset: the people, the things and the money.
And the difference is in the people. And the people determine how we use the things and how we use the money. And so the emphasis in this change is going to be around the people and how the assets get used. Now Harry will show so this is proposed structure that enables the change. And Harry is going to show a contrast between what we have today and where we're going.
And what we have today has brought us through the last phase, has enabled that growth in market share and that evolution of engines and the creation of the next generation of engines. So it's not bad, but the complexity that is buried therein has generated a huge culture of bureaucracy, slowness, duplication and just a culture of complexity. And we need to move to a much, much smaller lightweight corporate center. We need to have empowered businesses that operate with freedom, but freedom within a framework, not chaos. And I've deliberately pushed people in preparing these presentations that you're going to see this morning that we represent this as three interlocking circles, not three blocks of PowerPoint.
And the three interlocking circles are there because although these businesses face different market sectors, these businesses share intellectual property and share technology and share philosophy. So the synergy in our supply chain between civil aerospace and aerospace defense is obvious. The synergy between the power systems defense activities and our broader defense business is obvious in the customer relationships as is some of the technology. And the technology and service synergies between the Civil Aerospace business and our Power Systems business are there. And they're there to be exploited, But we do it in a lightweight empowered way rather than through the treacle of an overweight center.
So we're going to talk about accelerating culture change. Harry will go into a bit more detail than this, but I want to get across the message that simplicity is a state of being. That's what I told our leadership conference this year. And that is the sort
of
overwhelming state of being that you need to get to make this happen. So pace, pace is appropriate, but generally, I mean faster. And if you look at the complex situation we've come from, you have a chunk of people doing things in a complicated way. So it takes them a long time to do it, but you still got to do a whole load of things. And so you end up hiring more people in order to get more stuff done in the same period of time.
But that makes things even more complex. And so you get weighed down even further, and you get into a negative spiral or vicious circle. And that's what I mean by complexity killing and why we have to move to a state of simplicity. So pace and simplicity lead to efficiency, and that's enabled by a framework which is empowering. And that efficiency will improve our productivity and give us the world class business to match the world class technology.
And we're looking for efficiency in those three things, the people, the things and the money. So that's the message. And when we get there, we will have replaced the vicious circle or negative spiral by hopefully a virtuous circle, where, again, thinking about those three things, the people, the assets and the money, we those are key to create the outputs, which is market leadership and strong financial performance. So that's a little bit of introduction. We're going to step back from the restructuring program that we announced yesterday to give
a
flavor of what it looks like in a business that transitioning right now. So over to Andreas.
Thank you, Voron. Good morning, everyone. I'm very proud today to present Power Systems. And as Warren said, if you only get five minutes of an hour of your attention, I need to use my time wisely. Since I'm also new to Rolls Royce, a quick introduction, Andreas Kjell, 48 years old.
I started my career in Stuttgart with a company back then Daimler Benz, then Daimler Chrysler. Then I spent about ten years of my time in The U. S. And then followed by about four years here in The U. K.
I've also worked with Fiat Chrysler under private equity ownership and then later in my career, moved over to UTC and in the UTC Aerospace business. And then in December 2016, I was hired by Rolls Royce. And since then, I'm running the Power Systems business, and I'm very proud to be part of the Power of the Rolls Royce business. With that, let me kind of introduce Power Systems to you. I will since you're not so familiar with Power Systems or you may not be so familiar with Power Systems, I'll start with a quick overview.
But then most importantly, we have been driving a lot of change in the last one years, point and I'd like to introduce what we have done to make this business fit for the future and then follow and finish it out with our plans for the future and give you a perspective on what mid term you can expect out of the Power Systems business. All right. So I'm very proud to stand here on behalf of the 10,000 employees of Power Systems, and they sit mainly in 11 locations in five countries around the world. We sell about 25,000 engines and units per year. These include the lower power range that we do together with a partner.
The engines are grouped mainly in four product families: the 4,000 series, which is really the very, very famous main product line the 2,000 series then a series called classic engines, large engines, mainly the 8,000 series and then a smaller series called the 1,600 series. And they are used in 24 sub replications. The way we sell into the market is we go partially directly to the end customer, but we also sell through network. And this distribution network is a hybrid distribution network. So we have some of our own MTU subsidiaries in certain countries and regions.
And in other regions, we sell through third party distributors, so a hybrid network. And there are benefits for our business to do it that way. This gives us about 140 sales partners, but more than 500 authorized dealerships around the world that sell our product. The one thing that I find extremely attractive about the Power Systems business is the installed bases. It's more than 100,000 engines.
Now you could kind of say how does this relate to the 25,000 engines sold per year. The 100,000 units installed bases are the ones that we really develop and make within Rolls Royce Power Systems and MTU. Those are the ones that are mostly service revenue generating engine, and we'll come back later to what we do with the installed bases already and what we're going to do with that in the future. Customer concentration. Top 10 accounts for about 17% of the sales.
I'll talk about the customers later again, but I can tell you we have fantastic customers in the Power Systems business. Some key attributes. There's a lot that Power Systems has in common with the rest of Rolls Royce, a very high brand recognition, and we have a significant R and D experience in Power Systems. I think this is something that both have in common. But there are many areas where Power Systems can learn and has learned from Rolls Royce.
One area is the experience that the civil aerospace business has in aftermarket when it comes to developing products like long term service agreements, which is something that Power Systems didn't have. And I can tell you, within one year, because of the experience we have across Rolls Royce, we were able to kind of close the gap towards our competitors quickly and aggressively. But there are some things that are different, and they are good ones. When I look at the financial side, we have a very short cycle order book. There are certain engines that are standard type engines where we can fill the order book in three to four months.
The governmental business is the longer side of it, which about three or four years after order when we can put it in the order book. So again, a couple of months up to three, four years to fill the order book. The business enjoys a double digit EBIT margin, and it provides the opportunity, and as shown last year, that it has a very high cash conversion rate. The market profile. I said before, we have fantastic customers.
The customers are everything from small little family owned business that operate our engines, and they rely on the function of that engine day to day. If the engine fails, they can't generate revenue. But we at the upper range, we also have large mining conglomerates that are multibillion dollar businesses. But I can tell you what's common to all of the customers is the passion for what they do, and this is something that's reflected also within Power Systems. So diversified end markets and customers.
Revenue profile, about twothree coming out of OE, onethree generated out of service revenue, something we'll talk about that later again, that we will want to change and increase the percentage of service revenue as a total. Geographical split, 45% in Europe, but what needs to be considered in that number is that a lot of the European customers actually take the engines, generate systems and then export to global markets. Also noteworthy, between China and Asia Pacific today, 27% of the total revenue in that region and growing. Also noteworthy, 23% in The Americas. So we have to always monitor geopolitical situations and respond, and that's what we do in the business.
But well diversified, and that diversification has helped us going through downturns through down cycle situations, and we're not as susceptible to down cycles as other peers in the industry. Now let me talk about the what value we generate out of the market. The market itself is about 1,200,000 units or €27,000,000,000 of value. That's the total addressable off highway market, excluding automotive, truck and on highway applications. With our product lineup as we have it today, we can service about 440,000 units or CHF 13,000,000,000 of that.
Now we punch above our weight. We get 5% of the unit share, but we take 15% of the value of that market with our products. So we are premium in that segment all in. Let me introduce some of the segments that we do business in. First, Marine.
We are amongst the top three participants in the Marine segment. In Marine, we do mostly direct sales. About 70% of the sales we transact directly to end customers. Keep in mind, end customers are often shipbuilders. And then in the service, the end customer is the owner or operator of the vessel, so a multistage industry.
Applications, we are very strong in naval with a share greater than 25%. And I really like this, when you ever consider to buy a luxury yacht, the engine you want to have should have the MTU brand on it. And this is what a lot of the customers aspire. It really is something they show off when you go to boat shows, they open the engine rooms, and they are really proud for the technicians to kind of open it and show the MTU brand in their engine compartment, really something to be proud of in that industry. Projected growth, about a 4% CAGR.
And so we expect the market to be €2,100,000,000 in 2022. Second segment, and we like this even more than the Marine segment. Why? There is a lot of growth in the head in power generation. There is so much power demand out there.
And with what we do already today, we're right in the sweet spot of this. There is growth and there's about a 6.7% growth projected in power generation. Now we're very focused in power generation. We don't do everything. Our equipment is used in mission critical applications.
If you use your smartphone later on today, there is a very high probability that the backup power provided when the grid goes down comes from Rolls Royce Power Systems MTU. This is what customers are willing to pay a premium for. When the grid goes off, there is a battery storage that takes over for a few minutes, but then an MTU branded engine has to switch on and provide power within minutes thereafter and basically back up the facility. So data centers, hospitals, companies, everybody who needs reliable power, this is basically the market we care about. The other reason we really are very passionate about power generation is we are going to talk about microgrids later on today, which is a whole new different business segment, and I think we fit right in the sweet spot of that with our ongoing developments.
Again, we enjoy one of the top three market positions there. Products we sell in that market, 4,000, 2,000, 1,600 series, both diesel and gas systems. Third segment, Industrial. The industrial market is a bit different to marine and power generation, which are somewhat easy to introduce. This is a very complex and very diverse segment for us.
What you find in that segment is everything from railway application, oil and gas, huge mining trucks. Mining trucks, we have our engines on a mining truck with Belas, which can carry the weight, the takeoff weight of an A380 on its spec. There's two four thousand series engines that power up that truck, largest mining truck in the world. So very diverse. We're doing well in particular, railway, in mining, fracking, but also in construction and agricultural equipment.
Now this market is very sensitive to regulations, and they are not the same all across the globe. They vary strongly, so we have to kind of monitor this always. And that's why in that segment, you often have very special effects and cyclical behavior of that. For instance, right now, because of the introduction of a new regulatory emission stage coming next year. There is a pre buy effect in the smaller lower power range that we enjoy right now, but we'll have to deal with that then next year.
The reason I'm really passionate about this segment is all of these applications are heavy use applications. This is the best place to be for service. We'll come back later on. This is where we start connecting the engines because we need to monitor the use and the wear of the engines. Let me give you one example.
A mining truck. The engine in the mining truck is pretty much dead after three years. So it will come back and we basically repair it, restore it. And we can do this 3x over the lifetime of an engine. That means in about ten years, you have generated about 3x the value of that engine on that engine.
So this is how mining, for instance, works, for one example. 5.4% CAGR, but as I said, we really like that segment because of its potential in service. I'm not going to spend much time on this chart. But for completeness, we also work or we also offer our products in the defense sector. So land based battle tanks, infantry fighting vehicles and howitzers, it's a stable market with a recent increase in governmental spend.
We enjoy a bit of a future upside in that market. We also, after the realignment of the businesses across Rolls Royce, have now ownership for the civil nuclear business. There, we are present on 195 reactors in 20 countries. And I think all of you are aware, we just recently completed the sale of L'Orange to Woodward. While we have transacted this, we enjoy a long term partnership with L'Orange since injection systems are still an important part for our engines.
Now I'm very proud of this chart, really on behalf of my team. In the end, doing business and having fun with all of these end market applications is one thing, but it needs to translate into financial results. And I think you all agree with me, 2017 was a very strong year for Power Systems. Now a lot of people were quick to say, okay, the markets came back and okay, yes, the markets came back. We also were able to take share last year because we made changes in the sales organization, and we approached customers in a much different way.
In parallel to this, we also focused last year on cost reduction in the business. We took C and A down by 7%. We reduced R and D down by 6%. I'll explain later why we reduced and why we were able to reduce R and D, which then resulted in a two forty basis points gross margin improvement, and it allowed us to increase operating profit by 61% in 2017. How do I feel about 2018?
We've given guidance for revenue on high single digit growth, and I'm quite comfortable at this point in time with that guidance. Operating profits, I expect the margins to be stable, but there are going to be some effects. I talked about the pre buy effect in the lower power range. That's revenue, but very little margin coming along with that. And then in power generation, we will have less loose engine sales with higher margins, but this will be basically made up by more system sales.
So at this point in time, I feel comfortable with the margins being stable, and 2018 looks at this time to be yet another strong year for Power Systems. And I can assure you, we will continue to monitor and optimize our cost in the business. Now Warren talked about the importance of people being a strong and an important asset in the company. And when I talk about what we've done last year, this will also be a story about the people and what our people have done in Power Systems to make it fit for the future. When Warren asked me to join Rolls Royce in December 2016, I needed a few weeks to kind of do an assessment of Power Systems.
And here is what I saw. Here's my view on arrival. A bit of a personal story. My family comes out of the area in Southern Germany around Friedrichshafen, and I've always admired MTU. It was kind of like a dream for me at some point in time to lead this business.
And when you look at this blue and and red, they they resemble the flames in an engine. It made me really kind of wanting to work for that company. I was a little puzzled when I started how this icon, how this hidden crusher did not perform the way it should or it could. And here are some of my views. Positive, a real hinge for engineering.
Our people pride themselves, we don't play Premier League in engine development. We play Champions League. When we do engines, we do the best engines. So a hinge for engineering. A strong market share in niche markets.
But you wouldn't believe how proud our people were to tell about the stories when we kind of took in certain niches, pretty much everything away. There is a Marine segment where our engine has pretty much kind of gotten two competitors out of the segment altogether, but again, in niches. Super dedicated workforce and a transformation program that I felt was really, really good, maybe not kind of delivering the results yet, but it was a well set up program. There were a couple of things that I felt I needed to do to take a deeper look at. The leadership culture in the business, I needed to understand the core drivers of this business.
And again, when you kind of operate in such a diverse end market, this takes a little while to understand how you kind of generate orders and how you deliver against these orders and more importantly, how you generate margin out of that. I noticed an absence of digitalization, lots of PowerPoints about how digitalization could be, but very little in place. And there were some things that really required immediate attention. 20 of our portfolio was driving the majority of the profits. In fact, 20% of the portfolio also generated 80% of the revenue in the business.
By the way, a big dissimilarity between H1 and H2 financial results, very big disbalance between the two halves of the year, an absence of a customer focused mindset in the business. And then I think very similar to the words that Warren has chosen for the company, we needed to improve pace, simplicity and agility. There were always endless discussions. There was a governing body. It took about three months for presentations and for big topics to get to the top of the house for a decision.
And if we couldn't decide on it, it took another three month cycle to bring it back. We now have a much faster decision making cycle in the business. There is alignment on the top. There is very little time spent on protocols and minutes of the meetings, and there is focus on execution right thereafter once we come to an agreement in the business. So for 2017, the key focus was to address culture and leadership, number one.
80% of the folks that work with me, and I have one of my colleagues here with me, Matthias Vogel, who is in a new position, has been in the business for quite a while. He's the Executive Vice President of Network Distribution and Service, a new position we created because we needed to separate OE sales from service because they had to be focused on selling and focused on differentiation through service excellence. But 80% of the leadership team, we made changes. We brought people in from other industries, people in from the outside, but we also focused on promotions inside of the business through identifying talent. Sales and service, clear messages, putting the customer front and center, that doesn't mean to kind of sell for free.
And then, as I said, service excellence and different to create differentiation in the industry, Clear focus on product and quality. It's not that product quality was completely out of whack, but it wasn't there where you would expect the premium manufacturer to be so focused on that. We appointed a new Vice President of Quality, and he had the clear mandate to show everything that's not per standard. And so we have a bit to work through, but the results are stunning because the customer is experiencing a much, much different product already right now. On product development itself, more rigor on product development.
We introduced a new organization called product management to avoid generating self more rigor on product development. Introduced a new organization called product management to avoid generating small variance and pretty much not seeing the sales coming following through. And then last but not least, clear focus on cost and cash. The leadership team meets once a month, and we look this meeting is called Performance Assurance Meeting. It's a mandatory attendance meeting, and we see where we are against budget.
And it drives and promotes accountability in the business. When in the second quarter, we needed to focus on cash, we added cash as a KPI to this one, and I think the results speak for itself. But clear accountability in the business, no hiding in the organization, the people in sales stand up for their KPIs, the people in operations stand up for their KPIs, and we all come together. And if we're off, it's not a question how did we get there, it's a question what do we do to kind of mitigate this. And I think it has really sparked a different culture in the Power Systems business.
I said we had a transformation program in place, and it was really, really good. 15 work modules, we weren't in the position to really generate results out of that. That has changed. So twenty seventeen actions, I spoke already about the H1 versus H2 activity balance. This creates for a much better absorption in factories, as you all can imagine.
So to give you an example, Q1 in 2017, the factory was down for a couple of days because there was nothing to work on. We started on January with a full production schedule and the factory loaded. And that's what you want to have because then you have better absorption rates in the factory, and your cost basically is much better applied. Then direct material cost reduction, 4.3% material cost reduction. To be quite fair, the team has done material cost reduction for years.
The 4.3% was a little bit of uptick. We are now looking also at technical measures to take cost out. You don't always have to use the most expensive material. You have to use the material that works and belongs to the function of a part in an engine. And then very importantly, looking at target operating model, the way we work.
So we made changes to sales and service. We made changes in the engineering organization, changes in the quality organization. And I can see the benefits of it because there is more clarity. So again, coming back to the concept, simplicity. People understand what their job is, and therefore, we can operate much faster.
And then 2018 focus, ongoing product review, a lot more sales and service campaigns, focus on net working capital. And most importantly, I'll speak about this later on, digital, where we have made a massive improvement in just one year. Let me give you one example out of the transformation, and this is about product portfolio. I said I mentioned already 8020% of the product portfolio generating 80% of the revenue. So we had to really kind of take a look at the reprioritization of the engine road map.
There was one engine we had developed, and in years, we had sold five of them. Now we kept the parts in the business because, I mean, of course, if you want to sell it one more time, you need to kind of have the parts. So there are people in indirect who renegotiate supplier contracts for an engine that you don't really sell. So we put up an organization called product management, gave them the mandate to review this. Here are the results.
This started in 2015 already, but we are now down from eight fifty engine variants that you could order back in 2015 down to 600. And long term, we will be around 500 engines. And again, if an engine is taken off, we take the part out of the system. We'll keep a few parts in service because we need to stand by our customers should they ever repair on the engine sold, but that's it. So rationalization of the engine portfolio.
Now then that backs to the question, what do you do going forward to avoid this So there is no continued modularization. In the future, when sales comes back and says, here's a great application, think about industrial market, a lot of diversity there. We really go together and there's a clear assessment done. Do we really need that engine? And if we need it, how can we use the parts we already have in the system and take a modular approach?
Another thing we have done is the 1,600 series engine was always in its eleven years suffering from there were some variants that were selling very well, but most of the variants were sold at a loss. We didn't really make a lot of parts for that engine. Most of it came from a supply base in Western Europe. So that engine, I'll talk about this later, was moved into a joint venture with an Indian partner, and the supply chain will get localized in India. So and from there, we will basically then export to the global markets.
All right. So much about change in Power Systems. And now the question comes, what next? So I'll talk about key trends. I will talk about our strategy and the implementation.
And I will also speak for a moment about what I define success for Power Systems in the medium term. I could speak about this chart for hours, and I had to already this year a couple of times because it's so key for the business. Let me start with a very small anecdote. When I started last year, I have two sons, 14 and 12 years old. The 12 year old came one day home and said, so that all of this discussion about the diesel, isn't diesel everything you make?
Yes. We had the same laughter at the dinner table. I but it makes you think about the business you run. Now let's be clear. We play Champions League in diesel, and it's a pretty profitable business.
However, the diesel is not only in the public perception and the public discussion. The question also is, what do we do with this business? And let me be very clear. The diesel is anything else but debt. If you speak to customers in the outback in Australia, three flight hours north of Perth in a mine, thank you, in a mine, and you speak to them about alternatives others than diesel, you have to have a lot of arguments to convince them because diesel is a very energy efficient carrier, and therefore, they love it.
The same for Yacht customers in the end. Now having said this, there are clear rules and emission regulations out there that we have to comply with. In a yacht, for instance, a 4,000 series engine, you have to increase the volume by about 40% to incorporate future emission regulations and put exhaust gas after treatment on. So you give the owner of that yacht less cabin space and increase engine compartment space. That's not what yacht builders want to sell.
Having said this, so these are the key market trends, regulations and green policies all around the world. Norway putting a ban on any internal combustion engines in the marine usage in fjords, for instance. Alternative fuels and energy sources, a marine example, only 0.3% of all marine today is penetrated by the use of natural gas instead of diesel. So a big opportunity. Propulsion and electrification.
So we have customers who come to us and say, well, is there any chance you can do some sort of a hybrid on our application? Also, this industry, when you go to a mine, in mines as remote as they are, they are highly digitized today already, connected autonomous operation of mining vehicles, for instance. And then last but not least, I really believe the era of repair and spare parts comes to an end also in the off highway industry, therefore, thinking about life cycle services. So we really had to think about new solutions and new approaches for power systems. Integrated Power Solutions, again, we will continue to do diesels.
We're good at this, and there is no reason to kind of get out of it. We need to make sure that diesels are compliant to emission regulations, and that's very important to us. But we also need to be open to new fuels, gas. We already have a Marine 8V and 16V for a mobile application in gas. We have gas in our power generation lineup, and there are some product portfolio gaps that we are about to close.
We're also thinking about fuel cell technology, hybrids in two point five years from now in the marketplace and down the road on our road map also pure electrical solutions. Then system intelligence, integrated automation, remote and autonomous operating engines. And then last but not least, life cycle offerings. I mentioned that before already, this is where we really greatly benefit from the experience in the civil aerospace organization. So three key schemes.
We need to reshape our core examples and again, we need to retain a competitive engine portfolio, very important because that fuels everything we do for the future. But additional growth coming through joint ventures and partnerships and localization of production, life cycle services, digital enabled, which we'll talk about on the next page, and then turning Power Systems into a solution provider. Again, we are good in engines today. In the future, we will be very good at being a solution provider that requires us to do a bit of a capability buildup in electrics and automation. Reshaping the core.
We signed an agreement with Yuchai Power to establish a joint venture, and I was personally in the city of Yulin, which is about 300 kilometers away from the Vietnamese border. And I was personally there in April to take receipt of the first engine coming off the production line about one year, fourteen months after we had finalized the agreements with this. Working very closely together, so we have a couple of people from Germany who are permanently in the city of Yulin. We are not going to build the latest model of our 4,000 series engine over there. But because of the parts commonality, after localization, we will be able to kind of get low cost parts also out of Yulin for usage in other factories around the world.
And then we signed an agreement in April with Force Motors in India, and this is the localization of the 1,600 series in the city of Pune in a joint venture with them. They will do assembly and test of the engine, but we will we also plan to localize about 80% of the supply chain in India and then use it for the domestic power generation market and also export for global markets. Life Cycle Services. Life Cycle Services for me go hand in hand with digitalization. I cannot imagine how companies really will be in a position to talk about Life Cycle Services unless you really kind of make sure your assets are connected.
Because that drives advanced analytics and data driven value care agreements, in the end, you really need to know how you tailor your life cycle offerings to your customer. And we last year signed an agreement where we guaranteed uptime of the equipment. And as an example, here in The U. K. With a railway company, the duration of the agreement is twenty seven point five years.
You cannot sign an agreement like this unless you really kind of get the data to understand what you're doing there. So in 2017, as I said earlier on, we really didn't have a digital organization. So again, the leadership team got together in March. On April 1 and this was not a full state joke. On April 1, we started the digital organization with 40 positions.
Those were filled threethree of them threefour of them were filled by domain experts, by system experts from inside the company. And onefour came from the outside because for digital, we needed new capabilities there. So we started the digital unit. And today, we have digital products, whether these are applications. We started first with digitizing the customer interface there.
And by now, we have more than 2,000 assets connected. It's a KPI that I follow every week and every month very closely because, as I said before, there is more than 100,000 units out there that want to be connected. 2018 focus is continuously to connect the fleet, but we will also now embark into a horizontal digital transformation. And what we mean by that is that we will go rigorously through every function in the company. And inside Power Systems, we talk about X of the future, so service of the future, which I will show to you on the next page, sales of the future, factory of the future.
And every one of these functions has to own picture, and then we use digitalization to really kind of optimize the business. The digital team will be doubling in budget and the team size during the course of this year. So here is a picture on services of the future. And I'm sure you have seen these pictures before. Again, we did have very little to nothing about a year ago.
Many of the elements of this picture are in place. And for me, this starts with the customer. Our customers for their equipment want more uptime. And it's hard to see, but that makes them rest well, and it allows them to kind of spend time on their leisure. We, at the other end of the whole chain, we care about data because that data is worth to us a lot.
It helps us to kind of drive the business, make the right decisions within the business and steer the business. So this whole chain, if the customer is up there, he has he or that customer has their own operation center, and we are connected to this. So on the example of the train here in The U. K, these trains are connected. I could pull out my smartphone right now, and I could take a look where each one of these trains are operating.
And we had six failures of the engines. That wasn't good. Good thing is we were able to predict failure number seven and avoid that failure from happening and therefore, from disrupting the service of the customer. So now we on our end, we have a customer care center. This is where the data comes together.
There is a team permanently sitting there monitoring operations. And this team is fully empowered. If they feel there's a need to call Warren and get a plane orchestrated to get a part out there to a customer, they are empowered to do so. We didn't have to do that because so far we didn't need it. But this is the empowerment that team has to really serve the customer and make sure the equipment is in place.
Now downstream, it's very difficult for us to have all of the spare parts available. Wouldn't it be great for us to know the failure rates based on the utilization of the assets and have an optimized inventory management? That's the next step in the journey on services of the future. But as said, a lot of the elements of this picture after one year of work are in place already. Turning Power Systems into a solutions provider.
Now a solutions provider, it is a little bit more than selling product because you're selling all of a sudden solutions. And it's a different thing for the sales force. And that's why we talk very often about we need to develop new capabilities in the business. This is more about consulting the customer. So the way this works today, our people look into the spec, they negotiate with the customers sometimes about elements of the spec, but in the end, it's a product or a gen set or a marine system.
Well, in the future, a lot of the customers, especially in the energy market, asking for wider systems. And so we need to kind of develop our sales force and develop capabilities for them to become and act more like consultants. And this has implications on the product side, where we talk more about integrated propulsion, where we will talk more about microgrid. A microgrid is the combination of a controllable energy source and a noncontrollable energy source like photovoltaics or wind, an energy storage device and an intelligent control. Now we today, we do with gas and diesel power generators, one element of that one, we have started to develop a battery storage container made by MTU.
And I can tell you, it's been a very interesting product short time before launch. On the capabilities, we need to kind of embark more on project development. And then we spoke already about life cycle services and the advancements we need to make there. Coming to the end of my presentation. Where do I see the Power Systems business in medium term?
An average sales growth of 3% to 5% above GDP. Why do I feel this is possible? We will be we will continue with what we have developed and what we have in our pipeline to take share, and we will also embark in new applications that will allow us access to markets where and that we don't play in. Operating margins, I can imagine us being in the mid teens. Volume is our friend, and we have more volume than we had in recent years, so good factory absorption.
And I can see this trend continuing on. Localization also will help because it will allow us to kind of get parts at a lower cost. And I think one year ago, we were trailing I was a bit jealous on some of the peers in the industry. It was kind of hard to mention that we would get close to them. I think we have surpassed many of them within one year, and that's why I'm confident if we just stay the course and optimize cost in the business, we will continue on that trend.
The next line is a very important one to me, given all of the environmental challenges there to kind of lower our dependence on diesel as a main product. And therefore, 10% to 15% in the midterm need to get generated out of a nondiesel product line. And then I think also very important to change the split of OE and service more towards the 60 to 40 range, eventually even kind of doing better than that. So this won't happen overnight. But as I said, I can see us going there in a couple of years.
Last page. I hope I gave you a good impression of Power Systems and that you now know a bit more about this business. I really think this is a fantastic business. It has fantastic customers. With a great leadership team in Power Systems that has just started to work together to transform this business, there's more to be expected from us.
And there is a strong drive amongst the leadership team to transform this business into a solutions provider. I think we already have a very good position in the marketplace today, and we are a worthwhile investment. Thank you very much.
Right. Hello, everybody. I'm Harry Holt. I am the Chief People Officer in Rolls Royce. I've been in the company for just over seven years.
I've held a number of different appointments in our headquarters, in our civil aerospace business and most recently running our nuclear business division. Before I joined Rolls Royce, I had another career. I was an officer in the British Army for over twenty years. I commanded men and women on combat across the globe, and I also held a couple of senior jobs doing policy and strategy in the Ministry of Defense. I've held this role for just shy of six months.
And I have to say it's a very invigorating and exciting role to have for two main reasons. First of all, I always think that there's no such thing as good or bad companies or good or bad organizations. There's only really good or bad people and good or bad leaders. So being the Chief People Officer, accountable for making sure that we've got the right people and the right leadership, seems to me to be quite a stimulating and rewarding place to be. And the second reason why it's an exciting time to be in this position is because of the restructuring program that I'm about to talk about because I believe that it's a fantastic opportunity for Rolls Royce's future.
So I'm going to talk about ReStoreBat because I believe that it's a fantastic opportunity for Rolls Royce's future. So I'm going to talk about restructuring. I'm going to talk, first of all, about our approach. I'm going to talk about structure, culture, processes and people, and then I'll leave you with our next steps. So I think Warren was crystal clear on the requirement for restructuring.
After a period of really significant investment by the company, first of all, in R and D to develop a whole series of new civil aircraft engines. And secondly, in the capital expenditure so that we got the wherewithal to deliver those engines at volume. We now need to reposition ourselves, make ourselves fit for purpose for this next phase in our cycle so that we can generate the right returns on the investments that we've previously made and also so that we can achieve our longer term strategic ambition of being the world's leading industrial technology company. So with that goal in mind, how have we gone about trying to achieve it? Well, we have looked at more than just structure.
We've looked very thoughtfully and strategically at structure, culture, processes and people because, of course, the four are highly interconnected, and it's only by simultaneously changing all four that you can bring about the sort of lasting change that the company needs. If you just change structure, there's a real danger you just end up with the same old people operating the same clunky processes in the same old culture, but with just some different reporting lines. And we're categorically not going to do that. Instead, we focused on culture, structure, process and people, applying those four common principles of pay simplicity, efficiency and empowerment, looking not only at where we can potentially reduce activity and take heads out of the organization, but also where we may wish to enhance operational or strategic capability. Now Warren has been very consistent and clear on the principles of pace and simplicity.
They're both really states of mind, states of being, where in any given business circumstance, you ask yourself, how can we go quicker? How can we make this simpler? And efficiency is more than just doing the same for less. It's also about potentially doing more with the same resource. And empowerment is a theme that comes across very strongly every year in our annual employee opinion survey when our people tell us they don't feel fully enabled to do the jobs that we ask of them.
We have a tendency to centralize and elevate decision making as opposed to delegate decisions to those people that are best informed and most capable of making the decisions in a timely manner. So we need to invert that traditional hierarchical command and control pyramid, and that's the theme I'll return to later on. The outcomes are twofold: firstly, to generate better returns on the order book and the product portfolio that we have today but secondly, to make Rolls Royce more strategically resilient. And by that, I mean more capable of absorbing the inevitable ups and downs that happen in our market and at the same time, to invest in new technologies and growth for our future. So fundamentally, the restructuring program is a risk reducing measure for the company's long term future.
So what have we actually been doing since January when we announced our restructuring program? Well, we've been doing a very great deal. With the help of Alvarez and Marcel, who joined us in early February, but firmly led by the new executive leadership team, we have been doing a really rigorous diagnostic of the organization, which we've now largely finished. And we've also been developing plans for implementing the new structure. We've had a team of about 80 people working on this full time, about 50 from Rolls Royce and about 30 from Alvarez and Marcel, running a number of different work streams, each one of which is sponsored and owned by a member of the executive leadership team.
And in fact, the executive leadership team has met almost weekly to review progress on those work streams. We've managed to rack up over three thousand man days of diagnosis and planning. And We've used a number of A and M proprietary tools. We've used a number of industry standard tools like SQL and Tableau to help us to identify and visualize where we've got areas of duplication, where we've got areas of inefficiency.
And we've applied those tools to over 18,000 different job types, and that's given us sight of about 2,000 or so things that we can either completely stop doing or we can significantly change. We've also been doing analysis on our structure. So we've applied these tools to our structure and discovered, for example, that in areas of the headquarters, we have up to nine to 10 layers between the Chief Executive and the bottom of the organization, which is clearly far too many, and the new structure drives us down to about six or seven. Equally and linked very closely to layers, we've looked at our spans. And in some areas, again, often in the central functions, we discover that the average number of spans is down at about two or three, which is clearly too low.
And again, in the new structure, we'll push that up closer to 10. We discovered a number of managers who don't even have any direct reports. We discovered a number of technology projects that were still going, but now they seem to be misaligned with the original business objective that conceived them. As well as all the structural and activity analysis, we've also looked at the health of the organization, conducting an organizational health diagnostic, and I'll return to that later on. I think it's worth saying that from the outset, we asked Alvarez and Marcel to challenge us.
We asked them to make us feel uncomfortable. And I'm pleased to say that five months in, I'm giving them an 11 out of 10 on that front. So the outcome at a summary level, as you heard yesterday, is that we believe by changing the structure, simplifying the business, reducing the number of layers, increasing the number of spans, simplifying our processes and most importantly of all, stopping nugatory activity, we can reduce by about 4,500 jobs. And broadly speaking, they come out of the functional support. First of all, functional support in the center.
So the corporate center of about 4,300 will move to about 100 in our lean head office and about 2,600 in group business services and a number of functional support resource coming out of our businesses at the same time. So let's look, first of all, then at structure. So the current and old Rolls Royce structure was based on the traditional matrix model with a considerable amount of resource about 4,500 heads in the corporate center grouped into the traditional functional groupings of IT, HR, finance, legal, etcetera. And partly because those functional groupings were in the center and partly because they owned and controlled the majority of their resource. They were far too dominant in the matrix.
They were able to launch initiatives almost at will. They were able to insist on the businesses taking services that the businesses might not require. They had almost endless meddling rights. And the cost of all that, all that resource and activity was about £1,000,000,000 per annum, and that was then recharged back to the businesses allegedly in proportion to their size. But in reality, that meant that the businesses had almost no visibility of what they were being charged for, and they certainly had no control or ability to reduce it.
The matrix was complex, accountability was opaque, there was considerable scope for duplication of activity and decisions took a very long time to reach because almost everyone had to agree them. And if, heaven forbid, something went wrong, it was all too easy to legitimately point to somebody else in the matrix. So the new structure is simpler, focused on three empowered businesses, each one of which focused on our customers, enabled by a group business services organization, providing demand led support services for those three businesses at our best value for money basis and a lean head office doing corporate governance, group strategy and ensuring that we fulfill our corporate responsibilities as a publicly listed company. And we show this very deliberately with the customers and businesses at the top and funnily enough, the lean head office at the bottom because that signifies that inversion of the pyramid that I mentioned earlier on. So I'll just go through in a little bit more detail, starting with our three empowered businesses, Civil Defense and Power Systems, where we've made some minor adjustments to make them more customer focused and to make us easier for our customers to do business with.
So for example, putting Naval Marine and submarines into the defense business means that our defense customers now really only have to deal with one or two Rolls Royce businesses as opposed to three or four. Our Empowered businesses will be the absolute mainstay of the organization. It will certainly be where the vast majority of our people reside, and they will drive competitive and financial performance for the group. They'll have the maximum accountability for their own outcomes, consistent, of course, with overall corporate governance, the group strategy, shared value across the group and our corporate responsibilities. What that does mean is they now have accountability and authority for their P and L.
And most importantly, they get control over the support services that they require and visibility and control of the costs of those. They now get their hands on all of the resources they need to really continuously drive productivity, quality and performance improvement as well. Now as Warren said, we are very clear that we're not creating three independent fiefdoms. The businesses will all still share the same business model. They will all be developing advanced technology to applying to system solutions for our customers that we then service through life.
They'll continue to collaborate and learn from one another. Power Systems, for example, being able to take advantage of the decades of learning that we have in our civil business on engine health monitoring and long term service agreements so that they too can extract greater value out of the aftermarket. And our civil and defense businesses clearly share the same core gas turbine technology. They share a number of the same suppliers. Enabling those businesses, we have the group business services organization where we are going to effectively pull our support services, so our professional and transactional services, into one entity to drive value across the group.
That will have a real culture of customer service provider and a mindset where services are driven solely by customer demand and then measured solely through customer satisfaction. It will have a culture of continuous improvement, looking to continuously enhance value through process standardization, process simplification, leveraging the obvious economies of scale and then, of course, taking advantage of outsourcing, offshoring and increasingly robotics and automation. Interestingly, it gives us an opportunity for the first time to really create multifunctional, multiprocess end to end capability, and that's a bit of a mouthful to say. What I mean by that is that we have some of our big processes like Source To Pay, where at the moment, you have different functions managing different discrete elements of that process and therefore, all of the handoffs and interfaces between them, which is unduly complex. In this new model, we can put those people together into one coherent team to manage and improve that process genuinely from end to end.
I think Group Business Services will grow. I think the scope will grow as we learn and as we bring in new capability and as the businesses get used to working in this new model. And it will certainly be a very exciting opportunity to build and grow global and diverse talent. The lean head office, and you may spot that we got a leaner font on the word lean, just in case you'd missed that point, based in London, but in a new location, a new smaller location, more accessible for the majority of our people, closer to Kings Cross. And that will provide the senior leadership for the group.
It will provide the group strategy. It will ensure the disciplined allocation of capital consistent with that strategy. And of course, it will continue to provide corporate governance control and assurance. So moving on to culture. So culture, it's such a nebulous concept, isn't it?
But we all know that it is very, very important. I think the saying goes that culture eats strategy for breakfast. So in the same way as we conducted an analysis of our structure, we've conducted an analysis of our culture using an organizational health diagnostic tool, using our annual employee opinion survey and using Alvarez and Marcel to conduct a number of focused interviews for us. And the first thing that came out loud and clear is there is plenty about our culture that's really laudable and really fantastic, and we need to preserve and enhance. We need to preserve and enhance that sense of pride that all of our employees feel for working for Rolls Royce, and that engenders a fair sense of loyalty to our company.
We have a consultative and inclusive atmosphere, and that engenders very high degrees of innovation. But equally, there are some aspects of our culture that we certainly need to change. And I've just listed the sort of to and from on the right hand side of this slide. So first of all, we revel in complexity, we need to get much simpler and much clearer. So we have a thing called the Rolls Royce Management System, which is designed to provide people with the processes and procedures that they need to follow to get their job done.
That feels like an eminently sensible thing to have. But when you look inside it, you discover we've got 167 group procedures containing seven fifty one different steps, which are governed by 6,955 different rules. And if you look even further, you can find 3,424 embedded links to take you to separate documents providing how to guides and local work instructions. And in fact, if I printed it off and brought it here today, I'd have to cut down 28 trees to produce the 5,450 sheets of A four paper, and that's printing them on both sides. That is what I mean by reveling in complexity.
Maybe it's because designing and building the world's most efficient gas turbine aero engine is actually a pretty complicated thing. Otherwise, everyone else would be doing it. We somehow believe that complexity is an end in itself, and clearly, it isn't, and we need to become much simpler and clearer. We have a tendency to gold plate and duplicate. The Rolls Royce solution is not often not always a good moniker.
I remember running the nuclear business, we made a small acquisition in North America for about 5,000,000 to $6,000,000 only to be told by our own people that we were going to have to spend considerably more than that to bring the single facility of this new business up to Rolls Royce's group property standards. And this was on a building that had been cleared by The U. S. Regulator to handle nuclear contaminated material. We have a culture where we tolerate low productivity and poor performance.
Last year, less than 0.1% of the workforce left due to poor performance. I'll put some numbers on that. That's one engineer out of a population of about 17,000. I know we have some really great people, but they can't all be that good. So a much stronger performance management culture is where we need to get to.
One of the reasons why the performance management culture is poor is because the lack of accountability in our structure. It's really difficult to put your finger on someone and say, this was your accountability, this is how it's turned out, here are the outcomes, good or bad. And of course, the stories of internal approvals needing 25 or 26 signatures are more than just sort of anecdotal. They are symptomatic of an organization that shies away from individual accountability and somehow thinks that the more people that can take shared accountability, the better the outcome. And we all know from experience that it's often the reverse that applies.
And then last but by no means least, a lack of cost awareness. And of course, the danger of giving you lots of stories here is that you come away thinking that we're profligate, which we're actually have a lot of very good people working on cost reduction very successfully day in, day out. But we still have too many aberrations where we seem to incur ridiculous cost just because someone normally acting out of their best of intentions, thinks that they're upholding a group policy or standard. Again, in my last business in nuclear, I discovered that three people had flown all the way from Bolton to Grenoble simply to erect a Rolls Royce sign because they didn't trust a local contractor to be able to do that consistent with Rolls Royce's branding policy. So we haven't yet got the sort of cost conscious mindset that we need.
Now clearly, changing culture takes time. It's not going to happen overnight. It takes strong leadership. So the new leadership team that we have is really driving the cultural change. We've launched our new behaviors, our ABCs, we as call them, so be agile, be bold, be collaborative, be simple.
And those new behaviors are woven through our new leadership expectations, and we're increasingly judging people, judging leaders on how well or how badly they can live up to those expectations. And that will clearly have an impact on their performance appraisal, on their reward and clearly on their longer term prospects within the company. And as I mentioned earlier on, we are changing the leadership model, seeking to move away from that traditional hierarchical pyramid to invert that pyramid where leaders are less focused on how they control others and more on how they can build and develop and enable their teams to solve the problems that are in front of them. We call it leadership through people. I think it was Steve Jobs who says, it's not clever to hire smart people and then tell them what to do.
We hire smart people so they can tell us what to do. So our processes and systems are clearly another area which can help to shift culture. And of course, we need to simplify our processes. We need to reduce the process burden. Otherwise, we can't reduce by 4,005 jobs or at least we can't unless we want to have an organization that's got fewer people in simply working twice as hard to keep the old clunky machinery going.
So we've looked at a number of our processes, of which we've got several hundreds, many in the Rolls Royce management system, many elsewhere. And we've applied the four simple principles of stop, simplify, improve and automate. We've started with some of the biggest first, and I'll just give you a couple of examples to show you what we've achieved, but also to show you the opportunity for future achievement. So the management system I spoke about earlier, 167 group procedures, 44 of those procedures are to do with how we manage customer relationships and the services that we provide them. By putting together a small team, applying some good lean methodology, applying a good dollop of common sense, we've managed to reduce those procedures down to just 18.
And more importantly, we've reduced the ten sixty five rules governing those procedures down to less than 40. We've also had a lot of success with indirect procurement. Three years ago in 2015, we spent about GBP 2,700,000,000.0 per annum on indirect procurement using very outdated systems that lacked pace and lacked transparency. Over the last couple of years, through a project called IPEX, Indirect Procurement Excellence, we've introduced a new world class source to pay digital platform called Cooper, which is integrated across our ERP systems and across our major geographies. And at the same time, we've upskilled the buying teams and simplified our processes.
And the outcome has been very pleasing. We've managed to reduce the time it takes to process purchase orders by about half. We've managed to exceed the 5% industry benchmark savings in the various indirect commodities that we procure. We've reduced the total spend down from about GBP 2,700,000,000.0 in 2015 to a target of GBP 2,300,000,000.0 this year. And we've done all that with a team that's 23% smaller than it was.
So it shows you what's possible. We've also tackled our annual budgeting cycle, which Stephen, quite rightly, is very pleased with. Up until recently, our annual budgeting cycle took us ten months. We were in the cycle from April through to February. It involved over 10 well, tens of thousands of different spreadsheets all being developed bottom up.
And you can imagine the number of man hours that went into that. And at the end of it, in February, we then had a locked and pretty static budget. So by changing our approach, swapping all those thousands of spreadsheets out with one simple tool, driving the budget top down based on a few simple value drivers. We've now shortened that process to just a couple of months, September, October. And because you can change the assumptions on the value drivers, it is actually a dynamic tool and you can update your forecast whenever you so wish.
All that is sort of corporate office process improvement. Clearly, the businesses continue to drive improvement on the shop floor in our operational processes, where we continue to get really good results through a combination of lean methodology, but importantly, by empowering the teams and leading in that different way, leading through people. So for the XWB, for example, we've managed to reduce the snags on the build line by 27% simply by linking the engine fitter with the engine inspector by a new IT system so that each time the engine inspector sees something that's wrong, the engine fitter that caused the fault gets instant feedback. That was more than just a system improvement, of course. It's a cultural improvement where we work with the unions to make sure that the fitters were really embracing a culture of continuous improvement, desperately trying to drive the snags down and the product quality up for our customer.
Sticking with the XWB, obviously, biggest volume engine. We've managed to drive the turnaround time. Turnaround time is the amount of time the engine spends on the test bed before it gets shipped to the customer from 58 down to twenty two hours. The holy grail being to get it down to fifteen hours because if you can get all our large engines down to that sort of level, then we don't need significant additional test bed capacity. And a single test bed is about GBP 70,000,000 to 80,000,000 of capital expenditures.
So some of these simple operational process improvements as well as clearly improving our productivity and customer satisfaction actually can help to lower the overall investment bill for the company. So you can have the best structure in the world. You can have all the best processes in the world. You can have the best culture in the world, but if you haven't got the right people in the right jobs with the right skills and the right tools at the right time and most importantly with the right leadership, you are doomed. So our people strategy is absolutely essential to the overall restructuring, and it includes four elements that you can see here on this slide.
So first and foremost, we need to enhance our leadership capability across all levels of the organization from the top to the bottom and at the same time, change the leadership model to one where we lead through people and we enable our teams as opposed to controlling them per se. And we have rolled out, as I mentioned, new leadership expectations. And we're also going through a complete refresh of all of our leadership learning and leadership courses, not only so those new expectations are embedded in them, but also so that our leaders get a license to operate, as it were, before they move to the next level of leadership. Linked closely to that is improvement in our talent management to make sure that we've got the right leaders in the right place at the right time and also to improve and strengthen our succession planning. Three areas of focus here.
So first, to ensure that our leaders really understand that identifying and developing talent is one of their core accountabilities. Secondly, being much more proactive and systematic about how we manage people's careers, moving people across the company so that they can get the right experiences and grow the right capabilities so they can fill some of the biggest jobs in the right time frame. And then thirdly, being slightly less risk averse and conservative in some
of our
appointment decisions. And obviously, as we go through this restructuring phase, we've got a particular focus on keeping and promoting our key talent. This will all help with our diversity agenda. Diversity is important to us not only to make sure that we've got access to the largest possible pool of global talent, but it's also important because it's only by having diversity of experience and diversity of thought that we can be as creative and as innovative as we need to be to succeed. So diversity is all about creating better business outcomes for Rolls Royce.
And then finally, capabilities, where we have certain capabilities where we're strong today and we need to preserve them. So we do have deep functional and technical expertise that we want to preserve. We are innovative and we certainly need to preserve that. But there are other areas which need enhancements or indeed growth. We need more business and commercial acumen across the organization.
We need stronger program management in all of our businesses. And as we pursue our new strategy based around the two pillars of electrification and digitalization, we clearly need more electrical skills and data scientists in the organization. So next step. So yesterday, we made our announcement. That really signaled the end of the diagnostic phase of restructuring.
We've now very firmly moved into the implementation phase, and we will be beginning consultation with our people. You're familiar with the overall number of 4,600. And broadly speaking, we would expect about onethree of those jobs to be lost this year and the remainder to be lost during Phase II and Phase III complete by mid-twenty twenty. 4,600 is actually a very big number. I think it was Stalin who said one death is a tragedy, a million is a statistic.
And even though, thankfully, we're not talking about life and death here, we are talking about people's livelihoods. There are real people behind this slide with real families, real dependence and real hopes, dreams and fears. And so how we as a company treat them is of the utmost important. We will absolutely treat them with fairly with fairness and respect. We will make sure that we involve them as indeed we have done over the last few weeks and months.
We will involve them and their representatives at every stage of the process. And where we are selecting people into new roles in the new organization, we'll make sure that, that's a completely transparent process based solely on merit. All of that is important clearly to the people that are going to leave, but it's actually equally important to the people that are going to stay behind because it sends a very, very powerful signal of the sort of company that we are and we will remain. So can I just leave you with three messages? So as Warren said, having stabilized the business, having created and built and developed a new leadership team, we are now ready for this restructuring program.
And it is a program that focuses not just on structure, it's actually a really fundamental change to structure, culture, people and processes. The second thing I'd like you to take away is it's only by stopping, simplifying, improving and automating our work to reduce the overall burden on the system that we can let these jobs go. And then the final thing is that this is all about better results today, but it's also about preparing ourselves and building ourselves so that we're better positioned to seize and exploit the opportunities in our future. Thank you very much, everybody. I think we have now got a much needed coffee break and not Stephen.
Okay. I think we're all set. Morning, everybody. My name is Stephen Dainshith, Chief Financial Officer for Rolls Royce. Been here just over a year.
This session is around delivering the returns. And I think just to put sort of Rolls Royce in context, we're a growing business. We reported good growth in 2017. We expect to report good growth in 2018 revenue growth, and we expect that revenue growth to continue over the next few years as well. And we're also coming out of a significant investment cycle.
So we're entering the phase now of delivering the returns on that investment cycle. And today, we're going to share with you our two KPIs that we'll be tracking most closely to measure the success of those returns. Number one is cash flow returns on invested capital, and I'll talk quite a bit more about that a little later, and then cash flow per share. And just to give you some context as to how we've built this model up. And Harry alluded to it as well, and I talked a little bit about it a year ago, the half year results.
We're building and have built within Rolls Royce a driver based approach to modeling our business. So X times W divided by Y equals Z, with the three key drivers there, using that as an example, to get to an absolute number. And that way, we can better track performance and delivery of metrics and very much as Andreas was talking about in his business in Power Systems, tracking our progress. So we've developed this model, and this model allows us to develop a rolling forecast for Rolls Royce, whether it be over a five- or ten year period with great detail behind it as well. Clearly, a lot of assumptions driving that, but that's the essence of where we're trying to get to.
And in time, this rolling forecast will, in fact, replace the budget process because we'll always be updating our model on a driver based approach. What we're going to hear about this morning are the three key drivers. There are plenty of others, but three key drivers to deliver those returns. At the end of this session, there'll be about an hour for Q and A. So just to let you know, it won't finish immediately after me.
There is an hour set aside for Q and A. Right. Let me get into the presentation. What are the key drivers of the increased returns? And there are three significant ones: reduced OE cash deficit per engine the improved aftermarket cash margin and what we're describing as bending the fixed cost curve.
Important at the top there, underpinned by significantly increased returns across our three businesses. Andreas talked about those mid teen margins for Power Systems. We expect something very similar for our defense business as well. And our civil business, perhaps not quite at that level, but certainly moving up into the high single digits as civil progresses over the next few years. All three of those will drive and result in cash return on invested capital growing.
We've given a midterm ambition this morning around what that means. And midterm ambition, you should be thinking five, maybe six years, that sort of time period because I'm sure that question will come up. So first of all, looking at this key driver of OE cash deficits. There are three key factors behind the drive to reduce the cash deficits on our original equipment. As you know, we sell our civil engines at a small deficit today of about £1,600,000 cash loss per engine.
And through three key factors of pricing, cost and mix, we expect that to come down significantly over the next five years. And I'll be a bit more explicit about that on the next couple of slides. The Trent XWV84, in particular, we're highlighting we're highlighting as a breakeven engine by 2020, and that's a key driver of part of the journey that we're on. And there are looking at the cost reduction side, in particular, as a contribution to that reduced cash deficit, there are four key drivers of that: sourcing, engineering change, commercial terms and partnering and then how we manufacture the OE. Let me just give you some practical examples of what's happened within Rolls Royce.
So the Trent 7,000, for example, we've transferred the pipe supply from Spain into Mexico. We get about a GBP 50,000 benefit per engine from that. On the right hand side there is a fan case. That's this part of the engine here. We've reduced significantly the amount of raw material that we get before we start forging it to produce the finished design.
We've reduced it by around two tonnes lower per engine of raw material, and that again drives around 50,000 benefit per engine. So there's two changes. Thousand each. Commercial terms and partnering. This has been very effective.
We've worked with our suppliers to get improved commercial terms for them, at the same time, pricing for us and cost of the engine design. XWB eighty four and ninety seven in particular, driving a GBP 20,000 benefit per engine from that collaboration and working with our suppliers. We haven't always had a great reputation for working with suppliers at Rolls Royce. I would hope that we've dramatically improved this over recent years or certainly over the last couple of years or so. I would say on this whole area as well, the civil team each year have a very detailed list of initiatives to pursue along these lines to deliver that ongoing opportunity of cost reduction in original equipment.
Method of manufacture is important as well. We have a large DISC facility. Many of you may have visited it up in Washington in the Northeast, big investment going in there. I'm going to talk about this one in a second when we talk about the cash return on our invested capital. And that's delivered a benefit of about GBP 30,000 per engine.
So when you pull all that together, what does it mean to us in terms of cash flow over the next five years? Well, our widebody installed deliveries are going to grow from last year's four forty four to about 600 this year. And we lost last year, if you remember from the full year results, about £1,600,000 cash per engine. That £1,600,000 we expect to decline to about £400,000 over the next five years. So we decline by £1,200,000 per engine.
And using simple maths, we get to an average cash deficit reducing by that much and an incremental cash flow contribution to the group of about £500,000,000 per engine, number one of our key drivers. Number two of our key drivers is the aftermarket cash margin and probably the single largest driver, certainly one of the largest drivers. The key factors around this one, the growth in the installed base. I'll show you the numbers in a second. The flying hour growth that will follow that growth in the installed base.
Shop visits and how we expect those to develop over time. The in service issues. There'll be a lot of around this presentation that we'll talk about
the future and the good things that
are going to happen, but we shouldn't forget there is risk within our business. The Trent 1,000, the Trent 900 is a very good example of the risk that was within our engines of their performance. We assume a certain level of performance. The Trent 1,000 has shown that it doesn't always happen that way, and we're accommodating it this year and next year and so on. The risk and revenue sharing partnership program shares as well.
This is a significant part of the equation to take into account that we've modeled. This is going to grow quite significantly over the next few years as a proportion of our engines have a higher contribution of the partners that we've worked with to develop those engines in the first instance. So that's an important factor. However, having looked at all of that, modeled it through, this is where we get to on our assumptions. So the installed base will grow from 4,400 to around 6,500.
Here are the assumptions that we've taken, around five fifty to 600 deliveries per annum. And this won't be linear completely over the years, but it's pretty that's a good guide. And we have about 100 to 150 retirements per annum where we look throughout the aging of our fleet and so on as well. We've got 2,400 widebody engines on order. That's the 6,500 we end up with in 2022.
And this should drive a 10% growth in engine flying hours by 2022, getting us to that 6,500 number. Major shop visits, what's going on here? Well, these are the major shop visits, first of all, and then we've got check and repair visits. The major shop visits are when the engine reaches the point of its regular service interval, whether that be five, six, seven years. In 2017, we had two forty of those.
In 2022, we're going to have around six fifty. That's a reflection of the size of the growth of the installed base, but also looks at the maturity of the fleet. We have a younger fleet the most as well, which is helpful. The check and repair visits are the Trent 901,000 type visits that are out of the regular sequence of scheduling. So well over half the $350,000,000 number in 2017 was down to the Trent £900,001,000 So that's the area of most uncertainty in terms of how that develops.
2018, for example, that number will grow to maybe 500, 600 check and repair visits, depending on how we get through the inspections of the Trent 1,000 engines. The average cost of each of these varies considerably as well. As a good guide, you could use GBP 1,500,000.0 or so for the cost of a shop visit, a major shop visit. And in 2017, 400,000 per visit as a guide to what that number looks like as well. But I'm hoping you can pick up a degree of the granularity that we've gone into in our modeling to help us get to the midterm ambitions that we've shared this morning.
Two additional important levers down the bottom here, maximizing the time on wing, but also driving down the shop visit costs, both key contributors. So what does this mean when you pull it all together? We are aiming to exceed GBP 2,000,000,000 of wide body cash margin over the next five years, growing from 1,300,000,000 in 2017 to £2,000,000,000 in excess of £2,000,000,000 over the next five years. And we've taken certain assumptions here. So there's the bit that I've just talked about in terms of the installed base.
As a good guide, net of risk and revenue sharing partner percentage contributions, you should be thinking around GBP 500,000 per engine per year in terms of modeling this. That's a good guide. Talked about major refurbs. We talked about the check and repair. There are other parts of the aftermarket cost base that are outside of this driver based approach, things like the cost of leasing engines for the Total Care provision, transportation costs are in that number as well, and also the Engine Health Monitoring business as well and activity is in there.
The product in surface costs, these are any additional costs that might creep into the margin in respect of items like the 900,000,000 and the 1,000 An important point. There's often sort of speculation and commentary as to when this growth might slow down. We've modeled through the 20s to see based on what we think deliveries are going to be, what we think retirements are likely to be, looking at the aging of our fleet. And we actually see continued growth throughout the 2020s in absolute terms. Growth will slow down.
The rate of growth will slow down as the installed base grows and starts to flatten out, but also as the shop visit incidents per installed base starts to get higher as the fleet gets older. So the growth will slow down, but it will carry on growing throughout the 2020s. It's an important point. The third item, bending the cost curve. So what do we mean by that?
Three key factors that will help us bend the cost curve: the restructuring program that Harry talked through a little while ago the investment cycle, a significant investment cycle that we're coming out of and then the capacity that we've now built into our production capability to deliver those 600 engines a year. There are four components to what we call the cost curve. Commercial and admin costs, that's indirect expenditure. That's the amount largely that Harry was talking about in respect of those recharges across the businesses. Net R and D cash spend, you'll be familiar with that number, whether it be across civil, defense and power systems, and we'll show the profile of that in a second.
And then certification and participation costs. These are costs that go in, first of all, when we test the engine prior to delivery to customer, that's certification. Participation fees are the fees we pay to an airframer to participate on a program. And then finally, capital expenditure. These are the four areas of fixed cost, pounds 3,100,000,000.0 in total.
So first of all, bending the cost curve of the restructuring program. We highlighted yesterday, pounds 400,000,000 of net savings run rate savings by the 2020. It's driven by reduced fixed costs, but also headcount, simpler, more responsive business structure and efficiency and effective around the organization. Much more simple, less complex, lots of things that we're going to stop doing that we do today and deliver a more streamlined and simple and effective business. The savings will flow through.
Just thinking about timing, I think there'll be a small portion in 2018. Clearly, we've got a lot to do this year to start delivering. We have a target of onethree of headcount by the end of this year, but only a small portion this year. 2019 and 2020 will be the two years when we start to see those savings really flow through. We'll share more at the half year on the phasing of the savings.
In terms of the costs of the restructuring program, we have a GBP 500,000,000 cash cost estimate to implement, largely redundancy costs, but a decent portion of system investment to facilitate the delivery of this program. And you should be thinking roughly around, I would say, 80% headcount redundancy costs and the balance being the systems investment. As a rough guide today, again, we'll update you more at the half year results. In terms of timing, around 25% of that in 2018 and then the balance of twenty nineteentwenty twenty. I'd probably say about sort of the remaining 50% or maybe 60% in 2019 and the remaining 15% in 2020 as a rough guide.
Again, we'll give you updated estimates as we go along. The treatment of this will treat the costs outside of underlying profit and free cash flow. So we'll disclose the amounts, but we'll take it outside of underlying performance. Timing and impacts, we'll confirm again with the half year results. 400,000,000 of savings, pounds 500,000,000 of costs, so a pretty good payback.
So commercial and admin costs. This is the profile over the last few years of how these indirect costs have moved. 2014 and 2015 was quite a significant reduction driven by the absence of the energy business, but also by the fact that in those years, a bonus was not paid, to be frank, due to the performance of the business at that time. And that's quite material to our numbers. That's about GBP 100,000,000 or so of that number across the group.
But rising again to about GBP 1,100,000,000.0 that we see today, we expect those costs to reduce to around 5% of sales. That's our ambition. That's our midterm ambition. And largely driven by the GBP 400,000,000 of restructuring savings that we announced yesterday morning. Previously, with operation of about 8% or so, dropping to around 5%.
R and D. Putting this in context, our R and D net R and D has grown by from GBP 700,000,000 to GBP 1,200,000,000.0 over the last sort of seven years or so. Again, putting it in context, we have brought to the market six new civil aero engines during that period, during the last ten years. On average, civil NPI has been around 50% of group R and D spend. We're unlikely to see that period of activity again over the next ten years as we move into a service business after having been in R and D and OE business.
Very important point. So whilst the trajectory of that exact curve, don't read too much into the slope of that curve. The point is here that we do expect net R and D to decline rather than grow over the next few years. We will still be investing, as you might imagine, significantly in products for the next ten, twenty years, but not at the absolute amount level as we've seen in recent years. That's the key point.
The ambition to decline to around 6% of sales as the pace of civil NPI slows down. And at some point, we will again move into an investment cycle, but that won't be in the next sort of ten years. We won't see this sort of activity again. We're very much moving into, excuse me, an aftermarket space. CapEx.
Similarly, there's been a 60% increase in CapEx since 2010, up from 3% to 6% of sales. We've built in the capacity for our business to deliver those five fifty, 600 engines a year. So it's important to put Rolls Royce in context of the investment cycle that we've been in over the last five, ten years. 60% growth, we expect to decline to around 4% of sales on a go forward basis. That's our midterm ambition.
So bending the cost curve, what does it mean when you put it all together? We expect this is the rise from 17% to 23% of sales. Our ambition is to excuse me, our ambition, as we'll show on the next slide, is that this comes down significantly over the next few years. Putting this into practice and showing the numbers, we decline from around 23% of sales to 15% of sales over the medium term. So another one of our three the third of our three key drivers.
Contributes around GBP 500,000,000 per annum. So OE around GBP 500,000,000, aftermarket around GBP $750,000,000, bending the cost curve around GBP 500,000,000. All three of those will then help drive the improved cash return on invested capital and cash flow per share. Working capital is a key consideration. It is a feature of Rolls Royce.
It will continue to be so. We are a negative working capital business, but we have not included a material contribution from working capital in the modeling that we've got over the medium term. So capital allocation. How do we approach capital allocation? We have four key priorities across Rolls Royce as to how we allocate our capital.
Number one is a strong balance sheet Number two is to fund organic investments. Three is our reward payment to shareholders. And four is M and A. Let's look at those in a bit more detail. So strong balance sheet.
Why is it important? Well, credit rating matters for three key reasons. Number one, customer confidence. We do have, as we've shown on those previous charts, long term investment cycles for our aerospace programs. Multiyear service contracts, our customers need to be confident that they're investing in a strong and healthy business.
Number two, our competitive position. The credit rating does matter. It does matter when it comes to our debt and our funding. It's important, and it supports our ability to continue to acquire competitive financing. Thirdly, we run a very large hedge book, as you know, approaching $40,000,000,000 to manage our exposure to dollar inflows over the next ten years or so.
So a strong credit rating really matters. We have an ambition to return to a single A rating. All my conversations with the rating agencies indicate that they too have an eagle eye on free cash flow and as do we. So that will be the key guide as to the rating agencies view on free cash flow and rating. Number two, funding organic investments.
So how are we approaching organic investments? Well, the R and D and CapEx of around £2,000,000,000 that spend today across the business. First of all, increased rigor on R and D and CapEx across the board. We have an investment review committee that meets now every month. I chair that committee.
The majority of the executive team also attend that committee. We run through all the investment proposals. We have these are the four metrics against which we assess the credibility and attraction of each investment that's being put forward, internal rate of return, net present value, cash return on invested capital and also the maximum negative cash flow to the business. We prioritize our projects accordingly as well. And I was asked a question earlier on around sort of Power Systems getting investment in the business, for example.
Well, gets there is not one business that's favored. It's the returns that we favor and the visibility and credibility of those returns. So we shouldn't think necessarily that this is a civil aerospace dominant business in that respect. We have a suite of metrics provided against the balanced appraisal. You'll see them there.
We include within our investment proposals now mandatory minimum contingencies. There has been a, I would say, a streak of optimism in previous investments that have taken place, which has caught us out. Demand and cost scenarios are assessed to measure sensitivity. So we carry out rigorous sensitivity analysis to see how sensitive a proposal is to a particular individual assumption. We review them quarterly to monitor progress, and they must demonstrate a return 5% above our weighted average cost of capital of 10%, which is the group.
So we're targeting a 15 cash return on invested capital for each investment. This was this process was introduced in 2017, so it's still pretty new the way it's working today. But I would hope and expect it to make a significant contribution to Rolls Royce going forward, particularly how we look at our investments. Let me just give you a couple of examples of things that have worked well and one example that the things that haven't worked well. So our Washington Disk facility was £100,000,000 investment.
We delivered it under cost and NPV 24% better than plan, 50% lead time reduction, and this was despite a seven month slip in the program. Lessons learned, we use well proven production methods, knowledge transfer from previous projects such as Crosspoint in The U. S. And dynamic on spend phasing to cope with timing changes. This one worked well.
What didn't work so well? Well, this is a new engine control facility that we built in Birmingham, 35,000,000 increase in cost. So there's an investment cost of £84,000,000 so pretty significant slip. A two year slips at the time line, pretty bad net present value. And two years post launch, we'd underestimated the cost, twelve month delay as well.
One year later, that had got even worse. So lessons learned, increased rigor, segregated phases of breaking down our projects into individual time lines and milestones and put controls in place to strengthen the whole process through more rigorous and ongoing reviews. Capital allocation priority number three, payments to shareholders. So this shows our dividend history over the last ten years, rising from 14p through to 23p and currently back down at 11.7p per share. Free cash flow will be the guide for us as to when we reconsider our dividend.
That bullet point down here, that will be the key driver of how we look at our dividend and how the dividend might grow. We aspire to midterm 2.5x free cash flow dividend cover through the cycle. So this is our guide as how we're looking at dividend. We are committed to restoring payments to an appropriate level for our shareholders. They have been patient, and we hope at the right time when free cash flow is at the right level and the balance sheet is strong that we can then revisit the dividend.
Mergers and acquisitions, the key criteria that we use to assess M and A opportunities, alignment with strategy, their synergy potential across the group, value creation, again, linking in with that 15% cash return on invested capital, the cultural and management fit, but also our own balance sheet resilience, the ability to carry out and afford significant M and A. Technology, portfolio and growth are all key aspects when we assess the M and A opportunities that come our way. So measuring our success and pulling this all together into KPIs. And this was an interesting part of the exercise as we approach and say, how do we translate this into a couple of succinct and effective KPIs that we can use not just to report performance but also to manage performance across the business. There's no point having a cash return on invested capital KPI if you're not working that way within the business and rewarding our people through that KPI as well.
So it became interesting developing this one. We settled on these two, and here's the reason why. So again, around a year or so ago, I started here, I think then we made the point that cash flow was the key driver for us going forward of economic performance. Rolls Royce in the past has, I think, largely been a profit driven business and has benefited from long term contract accounting through using a profit measurement, whereas cash flow is the best and key indicator of economic performance. And our goal is to drive a cash flow culture across the group.
We've made some progress with that. We've got a long way to go, but it's a key part of what we're trying to achieve. So cash flow per share, this will be key to long term incentive plans, and I would hope directly aligned with shareholders' interests. Cash return on invested capital, it's a measure of investment efficiency. Let's just go through these two in a bit more detail.
So cash return on invested capital. Cash flow based, and this is the key aspect here is that it's not just cash generation itself, but it's asset efficiency. It's return on the investments that we've put into Rolls Royce. But it's R and D and capital otherwise can be quite a lazy tool to generate cash flow. If it's just cash itself per share in absolute terms, you're not looking at the efficiency of that investment.
And that's the way we want to work as a business and get our business managers working that way as well. So cash return on invested capital. How have we looked at this? A couple of things. We've worked a lot with Credit Suisse on their HALT instrument.
You'll all be familiar with the HALT tool. So this methodology is anchored in HALT, although it's not precisely the same as HALT. HALT starts with profit, we start with cash. It's probably best if I start on the right hand side of the screen here on the denominator. The denominator is the invested capital in the business.
And here's how we've arrived at our denominator of GBP 18,700,000,000.0 invested in the group today, at the 2017. So if you use the fifteen year historic net R and D investment. Most of these numbers, by the way, you can get from our annual report. And where you can't, well, the IR team will be helping the analysts show how we've derived these numbers. PP and E and software gross at cost, product, plant and equipment, participation and certification costs are on the invested capital as our other intangibles.
Working capital and provisions is in invested capital and operating leases are in there as well. On operating leases, we've used a perpetuity valuation of current operating lease payments to arrive at that invested capital for operating leases. An important point as well is that the deferred income from our aftermarket is not in the working capital number. Annual cash return. So then having decided what the denominator is, the invested capital, clearly, you need to approach free cash flow to make sure that you've got a right sort of apples and apples comparison.
So free cash flow, we then remove and add back to free cash flow, net R and D spend, CapEx on product, plants and equipments and software spend, participation certification fees, other intangibles, the inflowoutflow from working capital adjusted for the that's not excluded from cash flow, just to make that point, and then operating lease payments. And we come up with £1,800,000,000 of cash generation from our invested capital on a like for like basis anchored in Holt and a 9% return, therefore, in 2017. So what are we calling out today as our goal for the midterm? We've got a 15% target. Looking at that, it's important context is how the business model works for Civil Aerospace.
And we've put in here a very simple illustrative example just to remind us as to how Civil Aerospace works for a typical 2,000 engine program. Typically, it costs us around GBP 1,520,000,000.00 of R and D and CapEx for that engine program. We then have installed OE losses of around GBP 3,200,000,000.0. So that's the 2,000 engines at the GBP 1,600,000.0 loss per engine currently have today. And then on a go forward basis, over the next twenty five years, we have around a GBP 10,000,000,000 aftermarket cash margin that flows through over the next twenty five years.
That's the most simple way of looking at the business model of Civil Aerospace. So right now, we have quite a few engines that are just entering this phase of the cycle. Those six new engines that we talked about. Some are newer than others, but you hopefully, you get the feeling of where we are. So annual cash return on invested capital.
How do we expect this to develop? Well, you'll see that we've declined quite significantly over the last four years from 17% down to 9%. I guess one key point out of this is that we have been there before at high cash return on invested capital. Right now, the 9% shouldn't come as a huge surprise when you think about the dynamics of how the whole calculation and process works and the investment cycle that we're in at the moment and coming out of. So we're at a low for our cash return on invested capital.
We expect that to grow over the medium term, 9% currently and a 15% growth through the cycle. So how are we going to embed it in our planning? Well, improve returns on current invested capital. It goes back to my earlier comments really, making sure that as we review all investments, they're at least achieving returns that support our cash return on invested capital ambition. That's how we're going to work as a business when we assess our investment.
Cash flow per share. Very simple terms. This is much more simple, this one. We are dividing underlying free cash flow by the number of shares. Just as a reminder, underlying free cash flow is everything before dividend and M and A and currently the SFO fine that we're paying off.
Delivered by the three key drivers, but also underpinned by the three high performing businesses. Currently, our cash flow per share is around 15p. Over the medium term, and again, you should be thinking five, maybe six years to exceed GBP 1,000,000,000 cash flow per share sorry, one cash flow per share. That would be something. I think one thing I would say in respect of this midterm ambition, the model is there, the metrics are all clear, the road map is clear.
We've got a new executive team. We've gone from 14 down to nine executives over the last twelve, eighteen months or so. Pretty much everyone is brand new in the role. We have a team aligned around this ambition, determined to deliver it. But at this stage, it's just a PowerPoint.
And we shouldn't forget that. There is risk in our business. There's execution to deliver on as well. But there is a clear way ahead, and it makes sense the way ahead, and we're all determined to deliver it in our own parts, but also collectively. And that's an encouraging place to be, acknowledging though that currently, it is just a PowerPoint and there's lots of work to do.
So hopefully, that's given you a good indication around our ambition. And now I'm going to hand you over to Warren for some closing comments before the Q and A. Thank you very much.
Good. Well, thank you, Stephen, and nice to see everybody was awake for his rather ambitious cash flow per share target there. Anyway, I'm picking up where Stephen left off because to summarize, it's all about execution. So Harry talked about the state of the way we have been doing things at Rolls Royce. And that way that we've been doing things, call it culture, if you like, has been very, very resilient.
We've had a few generations of Rolls Royce management try to tackle this. And we've spent the last couple of years preparing because you can't just tackle it by wading in and cutting a few costs here and there because it doesn't go away. And that's why it's taken a little while to get to today. And as Stephen mentioned, a crucial part of that is the leadership team. But I think we have prepared over the last two to three years to get to this pivotal point.
And so even though it is just PowerPoint at the moment, and we all acknowledge the fact that the proof of the pudding is in the eating, and it is really all about the execution, I believe we are now prepared to execute. We're capable of executing, and we're determined to do so. And there are a handful of things from this restructuring that we absolutely must do. And driving out unnecessary costs, more often than not, that's simply about stopping doing unnecessary things. Removing the complex and duplicative processes, well, Harry described quite a lot of those sort of the duplication that's there.
So my favorite word, simplify, is really the next step to remove those processes so that we can get on to the improve and automate phase, which is developing a real performance culture. But behavior in that is key, and I'm looking for ownership behavior from the executive leadership team, from the senior leadership team and from the people in Rolls Royce. And I think because we're building on a very, as Harry said, proud workforce that is totally committed to this company, I think we're standing in a great place to be able to do that. So I hope you got the message from today. It's fundamental restructuring.
This isn't a short term thing. This is a moving from one phase of Rolls Royce to another phase of Rolls Royce. It's moving from building market share based on years of development through to using market share to deliver both returns and to deliver the sort of cash we need to invest to build ourselves a thriving future. How are we going to do that? Well, it's about empowered businesses and freedom within the framework, and that's really how we're going to implement simplicity.
And that simplicity enables the release of the benefits from all those past investments. And we had a bit of debate about this slide internally, and I insisted on using the word release rather than realize because actually, those returns have been there all along, embedded in the business model. And they're there for everyone to see. But unfortunately, they've been trapped, captured by the complexity and the bureaucracy of our operations. So I deliberately use the word release because now we're about to do that.
And my second favorite word, probably after simplify, is rigorous. Stephen talked about a rigorous investment process. And too long, Rolls Royce has had a fundamental confusion between detail and rigor. And that applies to our engineering, and it also applies to the way in which we've run the business. Now the good news is we've been learning some lessons, and I'm pretty confident that the leadership team now fully understands the difference between rigor and detail.
And of course, it's rigor that matters when we're developing success. So that rigorous investment process is very necessary. And it's also necessary to remember that you can't just do change and then sort of pack up and go away. It has to be a continuous process. I talked about being a leading industrial technology company, which means moving the market.
That means we constantly need to adjust and move and think about where we can do things to enhance our position vis a vis our competitors. And that's what will make us a really leading industrial technology company. So now we're going to have good news is we have managed to finish more or less on time that bit. So now we're going to go to Q and A. I'm going to sit down over there.
There are microphones, I believe, Jennifer. And he's got some, and we'll take your questions. Yes. Let's go. We've got one here at the front.
So let's start here, and then we'll go over that. Have we got two microphones? Yes. Okay. So let's have Eleanor over this side.
Thanks.
Yes. Thank you. It's Phil Bullock from Barclays. Just a few questions, please, and thank you for the detailed presentation. I guess it's obvious that it's a story of future cash flow.
But can I just start a little bit nearer term and ask about 2019, please? There do appear to be a number of headwinds. And if I look at where expectations were a couple of days ago, I think consensus was looking at around 700 or $800,000,000 of both EBIT and cash flow into 2019. I guess it'd just be helpful to know where we might be so we can help get the starting point of the bridge to the £1 of cash per share. The second question is on the shape of the underlying balance sheet leverage over the next couple of years as EBIT is obviously a little bit volatile near term, cash flow is depressed near term, and I guess IFRS 16 will also bring some lease liabilities onto the balance sheet of debt next year.
So where do you see leverage getting to come to the 2019? And should we assume that there's no prospect of the £1,800,000 of outstanding shares changing, I guess, over that time frame? And longer term, I'm just keen to get a handle on your top down assumptions of the market environment come the early to mid-2020s. Have the has Boeing launched the NMA? Do you foresee any pressure from transition pricing on wide bodies in a higher oil price environment?
And do you think that there's any prospects of narrow body aircraft impeding on North Atlantic routes and so on? I guess just the macro items, which are outside of your gift to control. Okay.
Thank you very much. Stephen is going to start in Okay. The first
So 2019 cash flow. Well, as you know, we don't we haven't given guidance on 2019. Our market consensus is just north of £700,000,000 or so. Think you know that we've guided to £450,000,000 free cash flow for this year and are on track to now go beyond the 1,200,000,000.0 in 2020. So I'm not going to give any guidance on 2019 right now.
As we normally do, we'll do that at the full year results early next year. But I think, clearly, somewhere between those two numbers is where we would expect to be, notwithstanding the headwinds, as you've pointed out, on things like one or two areas of working capital and indeed the Trent 1,000. But the growth that we see in the business and the other opportunities around working capital, I mean, good old fashioned working capital. We have over one hundred days of inventory on the balance sheet, for example, that we're having a crack at. And in classic sort of debtors and creditors, we have opportunities there as well.
As it stands, not giving guidance on 2019, but it's somewhere with a good step towards the number that we're looking for now in 2020. The next one was balance sheet leverage. There are no plans for shares, by the way, no adjustments to shares in that calculation. I think, well, clearly, cash flow growth will be a key guidance as we're looking at leverage and profit growth. We have announced the sale of L'Orange, which, of course, helps the balance sheet.
I'm sure there'll be a question later on Commercial Marine and where we are with that one. And we've got potential proceeds coming from that as well. So I'm not concerned about the balance sheet leverage. We are our rating agencies completely take into account those lease obligations that you referenced. And like ourselves, they're very focused on free cash flow, looking at the balance sheet and the strength of the balance sheet.
Warren, do want do that final So
and the third question was about market environment generally, narrow body encroaching on wide body space with transatlantic routes and so on. I mean, yes, of course, we can see that happening. And it's been a topic of some discussion for a while. When I've asked around about that amongst the customer base, it seems that there's always a trend to experiment and differentiate offerings and so on. But when you sit back and look at the numbers, then the potential narrow body encroachment on these long range routes is pretty much balanced by the wide body adoption on much shorter routes in populous parts of the world.
If anything, probably more so in that direction at the moment, but that doesn't mean to say that it will always exist like that. As for NMA, then obviously, a hot topic of debate and probably one question that you ought to address to Boeing rather than to us. My slightly guarded view about these things is that when you have a market in a couple of sectors and there seems to be a hole in the market, Quite often, there's a reason for the hole to be in the market. But that doesn't mean to say that things can't evolve. I think we need to go to this side.
It's Andrew Humphrey at Morgan Stanley. Just a couple, if I may. One is probably an extension of the NMA question, framed in terms of the midterm guidance. So if we're talking about five to six years from now in terms of how you're framing that midterm, We're talking about a phase where, as you say, you've come off the back of a significant surge in investments. You should be at a point where the majority of your installed engine base is relatively mature and operating in a steady state.
And you may or may not be at the point where you're about to kind of go into another ramp in investment into the middle and end of the next decade. With that in mind, should we be thinking about the source of numbers you're targeting in terms of that midterm guidance in terms of the cost to sales ratio as being mid cycle type of targets? Or is that a kind of this is how we think things should look when the business is actually operating pretty maturely and we've been able to optimize those cost ratios fully? And then I just have one more, if I may. Was just a kind of shorter term thing.
You've clearly talked about huge increases in terms of capacity to handle things like Trent 1,000 and the compressor blades. I think you sort of talked about traveling workshop capacity and a 50% increase in blade capacity. Those clearly aren't things that happen, but you can't build another fab overnight. So clearly, there's a lot going on in terms of processes there. Could you maybe talk a little bit about how you're instilling those sorts of practices and the kind of things that allow you to engage in that sort of very effective crisis management into the rest of the business?
Okay. So just on the sort of long term, how much R and D and what's the effect on NMA in middle of the next decade and so on. Clearly, if we don't do any new engine development, then the number is going to be a lot less than the target that Stephen had on the slide. We anticipate doing some new engine development. Whether it's NMA or whether it's larger engines based on our ultra fan architecture for wide body jets in the latter part of the decade.
It's a combination of those. And many times, we've debated the question in this sort of forum, and we've said, yes, specific NMA involvement will add 1,000,000,000 to £2,000,000,000 over a period of six to seven years to the development. Now whether that constitutes actually an upturn compared with what we've just been through or whether it is sort of sitting still within the range, I think it's probably more within the range. But having talked, Stephen has had a chance, I think, and he can answer that through cycle question. Before he does comment on the crisis management and the blade capacity and so on.
Two things. The blade capacity is something that we need anyway. What we've had to do is pull forward and accelerate a little bit some of the extra blade capacity that we need because of the size of the installed base, the size of the fleet that's out there that was on Stephen's slides shows clearly for normal MRO, we need more blade capacity. That's planned. It's been pulled forward a little bit because of the Trent 1,000 issue.
On MRO capacity, a similar thing exists, except that to deal with the extraordinary peak of activity around the Trent 1,000 issue, we have had to go for some more temporary measures in terms of MRO capacity. And that's why we've been able to triple specifically the lines available to deal with the Trent 1,000 issue. So this isn't we haven't suddenly tripled our overall MRO capacity. What we've tripled is the ability to deal with Trent 1,000. It has surfaced some fantastic behaviors.
In fact, I got a picture last night from our Head of Engineering in Civil Aerospace of a new engine stand that has been developed, approved, manufactured and sorted out all within the space of a matter of tens of days, I. E, about six weeks. And this has been driven by the crisis, obviously. But in terms of being able looking forward and utilizing that sort of lesson, then we can develop from that because this engine stand cannot only be manufactured in a very short period of time compared with normal engine stands. Compared with a huge cost of a normal engine stand, it's a fraction of that cost.
And it's basically applying the principle of switching from heavy bespoke furniture to IKEA flat pack. And one of the other advantages of the IKEA flat pack is that you can ship it around the world quite easily and get this stand to airline home hubs. And there, they can do on wing activity on the new stand. That would not have happened without the Trent 1,000 issue that we're dealing with now. It's a lesson that we can build into our normal activity.
So that's that. Do you want to comment on mid cycle Yes. R and
So we have included within our modeling and our statements an NMA scenario in there. And what that does is it just means sort of at most R and D will be flat. And if it declines, well, it just declines at a slightly lower trajectory of decline than it would otherwise do without the NMA. An important couple of points there. We will be looking for that 15% cash return on invested capital from the program.
So there will be rigor around this investment program having just brought a lot of MPI to the market. Clearly, want to have some rigor around this one. Another key important point, we've already spent around £500,000,000 developing the way we've got to with the UltraFans so far, which will be key parts of the architecture for any solution for the NMA should we choose to pursue it, that particular program. So it's not as though we have a standing start today in respect of this particular investment.
Okay. So I think we're over this side. Microphone coming up. Yes. Let's go to the front, and then we'll work back, if that's all right.
Thanks very much. It's Nick Cunningham from Agency Partners. I wanted to ask about some of the potential consequential risks from the restructuring process. It seems that you're doing two things, which one is taking quite a lot of people out or a lot of people out and the other is going from a quite a large HQ to a very small one with a lot of the resources spun out into the divisions. And so two obvious risks arise.
One is you've got a lot of commitments that you still have to fulfill in terms of development, production ramp, fixing the trend issues and so on. So would you have enough overall resources to deal with contingencies? And then the second one, which is probably a bit less obvious, but if you go to a very small HQ with powerful divisions, is it a risk that the pattern that we've seen at many companies in the past, be it Airbus, Leonardo and Lucas, whatever develops where you get barons running the divisions taking on risks which HQ can't control and which have adverse consequences in the end? Thank you.
Okay. Larry, are you going to go ahead?
Yes. I'll do the people, the first part of the question. So the key thing to, I think, stress upfront is that we're not actually taking any jobs out of people that manufacturing the current products or supporting the current fleet. So all the resources we actually need to deliver to our customers and support the fleet will be untouched. I think we're pretty confident about being able to reduce the number of sort of functional resource, largely for the reasons that I explained, that in the old structure, we had considerable resource in the center driving activity in the businesses that the businesses didn't really need.
And by stopping that, you can actually considerably reduce the number of functional people required.
In terms of the Barons, then I have taken a lot of care in developing the leadership team that we have and take a lot of care over stressing the importance of the fact that these people are executives of Rolls Royce who happen to be assigned to be doing this job or that job. And they work very much as a team. Their characters are chosen to fit in with that mold. Of course, it's a risk, but that is how we mitigate the risk, and that's my responsibility to deal with it. Now we're over this side, Richard.
Selene Fornaro from UBS. I've got three questions, if I may. The first one would be on Power Systems. I just would like to clarify for a change. And I'd just like to clarify, in terms of your progression, so you are including the civil nuclear business in your performance progression.
So are you tackling that business as well? Or does it just mean that the non nuclear business is outstanding performance? And secondly, if you can comment on your defense to only 3% CAGR growth when you look at some of the contracts or order book at Rheinmetall seems to be bit more ambitious than that. My second question would be on the business jet engine development. And any lesson learned from that development and how you did it that you could share with us to show that maybe something has changed in the Steel Aerospace business?
The first thing we noticed is that it was kept off secret for six years. And finally, would be on the working capital, which we haven't discussed very much. But if you could share with us the impact potentially of the culture change, yes, of support functions, but into working capital elements that you can control. So here, I'm really talking about inventories at group and aerospace level. Thanks.
Okay.
So Andreas is going to kick off with the Power Systems question.
Well, let me talk first about civil nuclear. Most of the progression in Power Systems is driven by the non nuclear part by the majority of the business in off highway engine applications. We've started to look at the civil nuclear business and at opportunities because power systems before already did backup power generation for nuclear power plants. And we're looking at synergies there on the sales side, but also kind of internally, and we'll progress on that as we go forward. Your question on defense.
We are the defense market for us is wider, and the 3% CAGR applies to the wider range of applications. So that's wider than just Rhinemetall, which would be the tank business, the battle tank business. And so the 3% is an aggregate number and really reflects a reasonable assumption about market growth in defense for the products we can serve.
Okay. So the second question was lessons from the recent business jet development and business jet launch. It's a market where you have to keep these things secret. The customers are very, very careful about not talking about their new generations until they're absolutely ready to go, contrast with the large airframers who talk about it for years. So if you want to supply and partner with those people, then you have to make sure you can keep that pretty secret as well.
I think we were lucky that the world didn't find out about that three or four months ago when actually it was certified, and the record was available for anybody who looked hard enough to find it. But fortunately, they didn't. And so it was a bit of a secret with the big reveal a few weeks ago. Lessons for us, small teams, very focused. Compared with our large civil engine programs, which are very dispersed and really the same sort of complexity disease that Harry was talking about more generally.
Some of those large civil engine programs have suffered from that. Whereas the corporate jet program, it's done essentially in one location with a smaller team, very, very focused. They've incorporated new technology in it in much the same way as we incorporate new technology in the large engines. And so I don't think there's much to be learned from that part. And one thing we've learned to improve generally on the business jet engines is going forward, we have just appointed the Head of Business Jets onto the leadership team of the Civil Aerospace business.
That person wasn't there before. That person was reporting in through all the programs. And I think we do need to apply a little bit more focus on the business jet programs at that leadership level because that development was a little starved of resource, which led to some program slippages. And so looking forward, we won't be suffering from that in the business jet programs. And Stephen, the third question?
Yes, working capital. Working capital is often all regarded as bad cholesterol, but there are elements of good cholesterol in working capital. And when I look around sort of Rolls Royce, there are plenty of opportunities to go for. Let me just run through those in sort of simple terms. So I won't give quite specific numbers because they are material, but I in terms of but the opportunity is significant.
So trade debtors, for example, we have a large balance of old disputed trade debtors to go for. That's a material number. We now have a team on the case in Civil Aerospace, dedicated team chasing these down. Actually have trade debtors right now today as we're approaching the half year that haven't have gone beyond their payment terms. So that's a good one to chase clearly, but attention to detail there.
Trade creditors, we actually paid a reasonably material number of our suppliers early last year at the 2017. And so getting consistent payment terms around our suppliers is an opportunity that we're getting into the detail of. The most material though is in inventory. When you adjust or look at our balance sheet inventory from a gross perspective, the number that you see on the balance sheet is net of provisions. We have almost 4,000,000,000 pounds of inventory, gross inventory on our balance sheet and well in excess of one hundred days.
And what we've done now is by business break this down by type of inventory, moving all the way through from raw material, work in progress, finished goods all the way through and spare parts. So we have by business, a number of days of inventory by type, by business. And there is a project team led by an individual naturally who is driving this through and working across the businesses to address the our efficiency around inventory. So lots to go for on inventory. It's not all bad cholesterol.
There's some very good cholesterol around working capital as well that we have dedicated teams working on. And your point about the culture of cash flow as well. I mean, we have this one of the four priorities that I have within projects that I have within the finance community generally is attention to working capital and attention to free cash flow. And there's a dedicated team just generally working on that, educating the businesses around the group on the importance of free cash flow, but also the other ways of looking at it through the balance sheet and not just through revenue and margins. Okay.
I think we're on this side. So Alan is working from the front to back on this side.
You. Rami from Investec. Two questions. One, you've talked a lot about the cost base and the improved cash. Can you also talk a little bit about the revenue line going forward, particularly around how you're working with the sales team to actually start and fill up the order book?
Order intake for a lot of your large engines hasn't been particularly strong over the last few years. And how you're working internally with your partners to fill up the hopper so when we get to 2023, you don't come off a cliff? And the second one is around digitization. And the Power Systems presentation was very useful. But can you talk about it from a broader group perspective in terms of investment, how much you're spending, how many additional people you are adding for that effort and how the negotiations with the OEMs on who collects the data, who manages the data, who utilizes the data is actually progressing given there's a lot of your peers investing in that?
Yes. So I mean on the backlog, and in particular around the large engines, we are following a product cycle effectively. And from around the middle of last year, then definitely activity has come off quite a bit. And I've been asked this question quite a bit, and I've delved into that quite a bit as well. It does appear to be a product cycle thing.
Orders did get ahead. And what we're seeing is activity in terms of rescheduling rather than ordering new airplanes. In terms of what can we do about that, well, of course, we are each major airline customer has a team within our Civil Aerospace business, small sales team with technical people sat behind that are engaged in a constant dialogue of reviewing people's fleet requirements and how they're changing their fleet requirements going forward. So there's no rocket science in it. It's classic key account management.
And we do it the same as everybody else does. I don't think we can do anything particularly different about that, except perhaps develop some of those relationships building on the second half of your question around the engine health monitoring, where we introduced the activity quite a long time ago. We've with the newer engines, vastly more sensors collecting data on the engines than used to be the case. And so we have invested in digital capability to do something with that. And we've probably been a bit tardy about making that investment.
But certainly, over the last eighteen months, we've ramped it up significantly. It's proved incredibly useful in terms of assisting with our classic engineering in diagnosing the Trent 1,000 issues. And at the same time, we're doing sort of business development activity with a handful of airlines at the moment. And I think that helps develop lock in with the airlines, which helps with the ordering process and the order intake in due course. End of the day, of course, it's pretty competitive.
And we're designed on certain airframes. Our competitors are designed on to other airframes. You take part in the sales dance at both levels, really, the airframe and in the case of 787s, then engine against engine and say no rocket science except perhaps for developing that customer relationship around the data. With you asked the question specifically about resource. I don't want spend a lot of time now on resource.
We can deal with that off line. So this side, yes.
It's Rob Stallard from Vertical. Andreas, a quick question for you. Power, what's the current sort of cash conversion or cash margin you're seeing? And do you see the same opportunity for that cash margin to progress in line with the operating margin target that you set out? And then secondly, Stephen, for you.
You talked about the rating agencies and trying to get your credit rating back up. Will they be using the same adjusted free cash flow number that you're using? Or will they be including the cost of the redundancies? Okay.
Andreas? I don't know if there's a specific cash conversion number for 2017 right at my hands, it's very high. There were a couple of effects last year, for instance, kind of doing a proper job on invoicing, completing project work. So there were some one timers, especially in the second quarter last year, that really helped us. Now very comparable to what Stephen said before, continue to work net working capital, especially the bad cholesterol part of the net working capital, is clearly a focus going forward.
We still and I gave you an example today how many parts we keep in our parts inventory. And as we go through this, I think we are still seeing opportunities on net working capital. But let's be very clear, this is not going to work over the course of a quarter. This will take a little bit of time to do this proper.
Yes. And just to add to that number, the cash conversion in Power Systems in 2017 was well over 100 percent, driven by the attention to detail that Andreas talked about in that second quarter on working capital and cash flow. And that was a big contributor to cash flow improvement for Rolls Royce generally on working capital. On the restructuring costs and the credit rating agencies, I have no doubt that they will look at the picture in its entirety. And I know we have Moody's in the room today, hello.
So I know you'll be looking at it and quite rightly too because it is the real sort of reported number and so on. But I think the route through to free cash flow growth and the savings that come from the restructuring and the pace of the payback from this restructuring are all good indicators that I would hope that we could encourage the rating agencies to see the world that way as well. So that's where we are on that one.
Okay. Thanks. It's over this side and it's working back. Well, we're going to finish working back and then the newer questions will come and take in one.
Back here, David Perry from JPMorgan. Also three from me. The first two are just factual clarifications, please. The first one, the 500,000,000 cash cost, is that a post tax number? And if it is, just what will the EBIT number be that you treat as exceptional, but just as a factual clarification?
The second one, also sort of factual, has a bit of forecasting in it, but I'm not getting into the rights and wrongs of anyone's ROIC definition. Everyone's got their own. But you leave the total care creditor out of it. What will that number actually be in 2024? Just to kind of help us think about that.
And then the third one, which is about guidance, and you may not want to go there, but I struggle, me personally anyway, with the lack of any earnings guidance to back up the free cash flow guidance. Can you give us any help at all in terms of 2022, 2024, whether it's EBITA, whether it's EPS? Just to help us try and triangulate the free cash flow guidance, please.
Okay. So the GBP 500 is well, the cost of the GBP 500,000,000 is the gross redundancy cost, in very simple terms, plus the cost of investment in technology systems, with finance being a key part of that, in fact, to deliver the savings that we have in mind. So that's the how got to the calculation. The Total Care cash sorry?
Just maybe I mean, I asked the question badly. Mean, is it GBP 500,000,000 in EBIT, which you'll treat as exceptional, and GBP 500,000,000 in cash or the EBIT and the cash number would be different?
That was all I was
They shouldn't be that different. They shouldn't be repeatedly different. The I would say the one thing is that the investment spend will be a capital item rather than a P and L item, the investment spend, if that makes sense. Is that what you're
getting Yes. Is there no tax spend applied to that?
Well, yes, clearly, there will be. There'll be that's an EBIT number. So there will be a tax benefit from the cost of those restructuring. Yes, there will in that respect.
So the EBIT is not going to be 700,000,000 that you treat as exceptional? No. Okay, sorry.
Okay. Total Care creditor. So I think the chart that we showed a little earlier sort of showed the business model for Civil Aerospace and how it works and how we include within our cash flow the aftermarket cash that we get in from engine flying hours after incurring the OE cash losses as part of the business model when we sell the engines into the airframers in the first instance. I don't have that number right now on 2024. We will have a think about it.
So I'm afraid I can't give you that. But clearly, it's going to grow significantly. And I think a key part of our balance sheet over the next few years, you will see a large deferred income balance grow. We talked about this before on our balance sheet in advance of our recognition of the profits attached to shop visits when they actually take place. So in the first four, five years or so of the new engine, we'd hope that there's not going to be a shop visit.
Therefore, you're collecting cash all the time, building that up on your balance sheet as deferred income and putting it in your bank state in the bank account. That's going to be a large credit balance on the balance sheet on a go forward basis, but I don't have the 2024 number to hand. And finally, on earnings guidance, too early to give you that. Earnings, as we pointed out at the full year, under an IFRS 15 regime are a lot more difficult to model because they are you model them around sort of frequency of shop visit and cost of shop visit and so on. So it's something that we are getting to.
Very much at the moment, our focus is on cash, and we've driven the model on that basis. At some point, I'd like to be able to share those numbers with you, but we're not ready yet.
Go on, Christian.
Sorry, did
I Sorry. We were trying to alternate like a game of tennis, but never mind.
I'm terrible
at tennis. Clearly, go ahead. Go ahead now. Started here.
Christian Lach from Bernstein. Just a couple of questions. One, starting at the high level. You've talked a lot about the restructuring kind of focusing on taking out layers of redundant layers of management and the personnel and how you found various pockets of opportunities on that. But so far, you seem to have ring fenced the factory floor with respect to both personnel and also to so I was wondering if you can address that, if that's a future phase?
Or are you happy with the headcount or personnel deployment in the factories, relating to direct manufacturing costs? And then additionally, around where you see additional investments with respect to tooling, maybe automation down the road. Automation was alluded to, but maybe some more detail on that. So I guess my overall question is, is there sort of like a next gear or next phase in this restructuring as we look down the road that more directly deals with direct manufacturing costs? And then the second more tactical question is, with respect to the recent issues on the Trent 1,000 in particular, how confident are you that you won't see similar issues crop up later with the XWB family or this Trent seven thousand family, assuming that you've run these programs to ground to look at this potential risk?
Yes. I'll pick up the first part of that on sort of possible reductions on the shop floor. So over the duration of this restructuring program, which is the next eighteen to twenty four months, I think we've got sufficient visibility of the load on our factories to be very clear on what headcount we need to deliver that load, those products to our customers. So we're comfortable that the number of people we've currently got is actually what we need to deliver our commitments to our customers. And in certain areas, Derby, for example, we have agreements with our employee representatives to protect against redundancies over the next sort of twelve to eighteen months, and we'll make sure that we honor those.
So for the next, as I say, period of the restructuring program, we feel that we've got the right level of resource to deliver on our current commitments to customers.
Okay. And in terms of where that goes in future with potential investments in new manufacturing technology and so on, then of course, we're doing that. And of course, at some stage in future, we may have significantly more automation in our facilities, and that may mean that we can free up some of the people. I would stress, however, that because of the installed base growing, the demand, particularly for the components, is going to increase over the coming years rather than decrease. And so it could be that you'll see our headcount be fairly flat in that part of the business, but our actual output continue to rise as we benefit from more automation.
Question on XWB and Trent seven thousand and what about the risk of the issues we've seen on Trent 1,000? Well, we cannot be sure about XWB and its sort of and the durability of all the components until 20 to 30 engines or so get to the first shop visit, and it's simply too new. We've probably got about another fifteen to eighteen months to go before we reach that stage. So it would be foolhardy to sort of say yes. However, in terms if I look at the issues that are prevalent on Trent 1000 at the moment, then we see no evidence at the moment of the turbine issues occurring on XWB.
I look at the design that went into XWB, it was a different design flow. It was more modern tools that we used. And obviously, because of the issues on Trent 1000, we're doing an awful lot more inspection of XWB engines now, which is giving us still a lot of confidence that we're not seeing early signs of the turbine issues. As for the compressor issues, then basically, we've checked the arithmetic, and the issues are not going to occur as we've seen on Trent 1000. On Trent 7000, then, as you know, it is derived from Trent 1000.
And so what we will be doing is making very certain when we start making volumes of Trent 7000, which we haven't started yet, that any modifications that and design improvements that we can take from the Trent 1,000 will be incorporated into the Trent 7,000. However, from the testing that we've done on Trent 7,000 so far, we're not seeing a potential for those issues, but we will make absolutely certain. Trent 7,000 will enter into service later this year towards the end of Q3. And the volumes of Trent 7,000 that will be manufactured before such time as the final fixes in Trent 1,000 are available are very small. So if there is an issue, it will be a very small contained issue.
So hopefully, that's enough of an answer. Now we must do two questions on this side.
Zafar Khan from SocGen. I have three questions, please, if I may. First one is just on the engine OE deficit, Stephen, that you were showing. Yes. And it's very encouraging to see that on the XWB-eighty four, you're talking about breakeven in 2020.
Yet for the portfolio, you're talking about a 400,000 deficit in 'twenty two. So where is the so if I'm averaging because that's an average you've given, that means something is losing a lot more than that. So could you help us understand that, please? That's the first one. The second one is just on this ROIC.
By the way, think WACC of 10% seems a little bit high. But I don't want to argue about that, just noting that as I asked the question. The 15% number that you've got to, how did you get to that number? Is it a peer group comparison? Is it some benchmarking you've done?
So if you could help us understand And then I have a question for Andreas, if I may. The 100,000 units that you want to connect, the digitalization, how much is it going to cost to connect, say, one unit? Who bears the cost? And how do you account for that? Thank you.
So the OE deficit going to £400,000 per engine. So yes, your XBB84, correct, going to breakeven and a large proportion of what the mix will look like at that point. But we also have new engines that are part of that. So this we tend to find that new engines launch pricing tends to be less keen than a mature a more mature engine. So the and the 7,000 and the XWB 97 are the two most significant examples of that.
So it's that feature that allows us to only get to 400,000. I say only get to, but if you look at the context of the mix and the volume, that's still for the other two engines would still be an improvement on where it is today. And certainly, I think getting roundabout or close below the 1.6 average in any event, so making progress. So it's really all about launch pricing of the younger engines. The cash return on invested capital.
So we have a group WACC of 10%, and we arrived at this by looking at our cost of capital, the beta of Rolls Royce. And we have quite a high beta as it stands today when you look around the risk that's been attached to the business in recent years in terms of our profit predictability, so to speak. We have a 15%. We are comfortable with it. I think it gives us it's a good risk management tool.
We've approached it that way. I should make the point as well that we actually have different working weighted average cost of capitals for different sectors. So for example, the short cycle businesses have a lower weighted average cost of capital than the long cycle businesses. So for example, Power Systems might be sort of, let's say, 8% weighted average cost of capital. The cost plus businesses like defense, where we're on a contract and it's cost plus, but it's quite a small margin.
Cost of capital there might be 6.5% or so. But Civil Aerospace, a longer cycle business, 12.5% cost of capital seems more appropriate. So the five percent is a good guide, a good we believe it's a good risk metric, particularly when we look at previous experience of our investments. Some have gone very well, one or two have gone not so well. And I think the 15% is the appropriate hurdle rate we ought to be aspiring for Rolls Royce.
So that's how we got to 15%.
To the connection of the fleet, first of all, I said it's greater than 100,000 units in the field, but not all of them need to be connected. There are some of these applications that have very low utilization. There are some marine applications where engines get a few 100 per year. There are some backup power generators that only get a double digit number of hours per year. So you really don't need to focus on those applications, but we focus, as I said before, in industrial, for instance, on high utilization assets.
The cost to connect such an asset is actually threefold. It's the technical connection, so a technical unit that ranges anywhere from €80 per unit up to €500 up to €800 per unit for a very complex marine application that you need to make seawaterproof and ready for the ambient conditions over there. That we would need to include in the cost for future engines, and that's already kind of planned in. Then there is the cost to really kind of transmit the data. That ranges all the way from very simple UDDC protocols that cost you about €1 per month, but it can be also a bit more expensive.
And then the third bucket is basically to host and analyze the data. And we will kind of work with our customers. Some of that will be borne by the customers, some of it we will bore there because we actually kind of both have benefits on this when we talk in terms of long term service agreements. What's really important to note is long term service agreements have actually two winners. It really kind of actually gives a shared benefit, and therefore, I think it's fair.
And I've seen so far a very positive reaction from the marketplace.
Great. Thanks, Andreas. We've actually got a couple of questions coming in online. So we'll take those, and then we'll have to move to the final questions because we're going to run out of time.
Sorry, thanks. Just a couple online, one from a large shareholder. Some of your GBP 11,000,000,000 of R and D since 2010 will have been on concepts with no real revenue attached to date. Do you sort
of have a sense as
to how much? But importantly, are there any concepts coming out of the R and D which you look to have exciting addressable markets coming from? And secondly, do you see any material risk to your aftermarket revenue expectations from Airframers' own ambitions in this space?
Okay. So if I look at the £11,000,000,000 and take the sort of rather rule of thumb that Stephen mentioned a little while ago about roughly half of the R and D expense coming from large civil aerospace NPI for the last several years. So we've got half of the remainder or sorry, we've got half of it as a remainder. I actually don't know the answer to how much of it is concepts that haven't gone anywhere. But I suspect it's probably no more than 20% of the remainder.
So about oneten probably of that number in total over the last however many years for the GBP 11,000,000,000 will have gone on concepts where, frankly, we haven't got much of a return. We may get some return in future. And an example might be, for instance, our fuel cell joint venture, where, frankly, right now, I can't tell you what sort of return we're going to make on that. Seemed like a good idea when the original investments were made, and it may materialize and turn into a good thing in future. Sorry, Ross, what was the second half of that question?
Any coming out which excites you? Any terms of concepts which you can see in the Yes. Interest in
addressable So I think we've been fairly open. Some of the more exciting concepts are probably around the advent of electrification. And you saw us sign an agreement with Airbus shortly before the end of last year. We that program is on track. We still, with Airbus, hope to fly the hybrid demonstrator in 2020.
That sort of thing is exciting. I mentioned fuel cells a moment or two ago. There's all sorts of other interesting alternative fuel cell type technologies that could be used for the storage medium in the hybrid systems in the microgrids that Andreas talked about earlier. So we've got one I think we've got two over here, if you don't mind, Tony, and then we'll come back. So we've got two here, and then these are the final three questions.
We'll try and be quick.
Derek Johnson, Nytorum Capital. I wanted to talk a bit about the cash return on invested capital metric. So you have that going from 9% to 15% through the cycle. My question is that's an increase of like 60%, 70%, but yet you have cash flow per share increasing 7x from last year to your midterm goal. So just trying to reconcile those two metrics.
And also, what is the cash flow per share goal throughout the cycle? Like because I think your slide said in 2015, that metric is 14%, and cash flow per share was significantly less than GBP 1 per share. So just trying to better understand through the cycle numbers on cash flow per share.
So right, so cash return on invested capital. Sorry, could you just go back to the first part of the question again? I was thinking more about the cash flow number there, the first part of So
the metric is going from 9% to 15%. Roughly speaking, that's increasing 60%, 70%. I would actually think the denominator would be going down as you exit this investment cycle. So I think it would actually be higher. I mean it's pretty comparable to the number in 2015 when I think the slide showed 14%.
Yes. We have worked hard to ensure that these two are, as you might imagine, in tandem with each other. And it can be quite sensitive to any assumptions around the base of the invested capital. So I can assure you that we've got the model correct so that they too do sync up with each other. And the next
We might have to come back to you on
that And and then to show the math on
then in terms of mid cycle capital per share versus medium term?
You mean sort of in the period in between sort of where we are today and where we get to?
Well, the slides show 15%, it says through the cycle, but the cash flow per share just says medium
term. See.
Through the cycle. So is there a difference between the two?
Well, I guess the cash flow per share is more sort of a point in time to exceed GBP 1 per share of free cash flow. We would expect that to grow free cash flow. We'd expect to see continued growth in the business. The cash return on invested capital, 15% through the cycle. What we're trying to get across here is that, that's sort of on a steady state rolling basis, that's the sort of cash return on invested capital you ought to see out of Rolls Royce, that sort of 15% number.
We get to that number by midterm, that sort of five, six years from now. And then the sort of the average ought to move in that direction as well to 15%. I'd look at it that way. That's what we mean by through the cycle.
So penultimate question on this side, and then we're going over to that side for the last one.
Andrew Gollum from Berenberg. Penultimate questions, if will. So the first one is on the Pearl engine, and while I'm keeping it secret for so long, opportunities there. Are you targeting, for example, The Hemisphere, which is facing a similar issue to Datto last year in terms of delay into service? And if not, what other opportunities if, of course, you don't have to keep a secret?
So that's the
first one.
And the second one, to Stephen, just to reconcile, keep going back to this working capital thing, reconcile a couple of statements you made. You've answered some questions just now that indicate big opportunities within working capital. But I think in your slide presentation, kind of implied that there were no I think there was no material impact from working capital
changes
in the assumptions and the guidance you're giving today. So can you just help us understand what you're telling us?
Sure. So on the Pearl engine, when we launched that in conjunction with Bombardier the other day, we launched the Pearl Bla and talked about a Pearl family. And we deliberately talked about a Pearl family to imply that the engine which has been launched is not the only one that we hope in the family. However, as I said, it's a sector which is characterized by secrecy. And therefore, we can't talk about other family members that may or may not exist in future because they tend to be in conjunction with one of the corporate jet airframers.
It is our ambition to more than recover the position that we lost in market share in large cabin business jets. So as far as I'm concerned, any of these large cabin opportunities are up for grabs subject to, as we've talked about this morning, if that means developing an engine with a sub business plan that doesn't make sense according to the rigor that we are intending to treat these projects with, then we'll find other ways of doing it. But definitely, the opportunities are there, and we're going to go after them.
And on the cash flow, so working capital. So what we've done, we've normalized free cash flow to exclude the benefits or negatives positives or negatives of material working capital movements. So because in our view, it would be wrong to include a number that's a target that includes a significant working capital benefit in that year because, of course, you can only do working capital once. You can't do it year after year after year. It becomes much, much harder.
So we've taken out that distortion. Clearly, we're not going to leave working capital on the balance sheet and where we do see opportunities to get more efficient on our asset base. And I talked about whether it be inventory days, trade debtors, suppliers and so on, we will pursue those opportunities. But we've purposely normalized our cash flows so we don't get any distortion from those impacts. That's what we've done.
Thank you. Sandy, would you like to ask the last question?
Yes. It will be swift. I'm just really asking you just had a little squabble or it's unfolding over here. If any member of the finance team had inadvertently said free cash flow to exceed £1,200,000,000 in 2020, that was a slip of the tongue rather than him reading the budget there.
I think I know what you're getting at here. I mean, think with £400,000,000 of savings delivered by the 2020, I mean, clearly, it will be hard to dispute £1,200,000,000 in 2020. And that if pushed, that would be as kind of sensible guide the way to be thinking around that sort of number now that we've said that we do expect to exceed to £1,000,000,000 But clearly, there's a lot of puts and takes along the way. We're in the middle of managing pretty significant issues on the Trent 900 and the 1,000 and how that evolves. That's a risk around the business.
So don't treat that as a sort of hard and fast number. We've made the point that we do now expect to exceed £1,000,000,000 in 2020.
Okay. And I'll follow-up with Harry, if he doesn't mind, on how you avoid these rationalization people. If I can how do they screen you out?
Okay. Right. With that, we're done. So thank you all very much for coming this morning. We appreciate the support.
And we'll be back with our half year results at either the very July or the August. I'm not quite sure now, but thanks for coming.