Rolls-Royce: eastern promises

Seen at a certain level of abstraction, it is a record to be proud of. In the four years that John Rishton has been running Rolls-Royce, revenues have grown 10 per cent a year. Dividends have increased just as fast and the stock is up 66 per cent. Investment has risen significantly, yet the company remains debt-free.

Still, the Rishton era - which ended on Wednesday with the news that he would be replaced by former Arm Holdings CEO Warren East - will be remembered with mixed feelings. The past year or two have been marred by repeated cuts to the company's profit targets and the shares have underperformed peers it had previously outshone. Free cash flow has not followed the positive trajectory taken by revenue or accounting profit. Aerospace margins still lag badly behind those of rival GE. A UK Serious Fraud Office investigation of bribery in Asia, which began in 2012, has not helped.

Most importantly, there was the 2011 decision to exit the International Aero Engines joint venture. That took Rolls out of the narrow body aircraft engine market, presently the fastest growing sector of the industry.

Mr East, then, has plenty to do. First, he must improve the way Rolls sets market expectations. After years explaining Arm's unique and complex business model, he should be well qualified to do so. He should set a small number of very clear long-term targets and help investors see past the unimportant quarterly shifts. This is especially crucial because of the large number of new engines the company is delivering for the Airbus a350. They will crimp margins for years to come: the real profits come after delivery, when long-term maintenance contracts kick in.

Second, Mr East needs to rethink the company's portfolio. Its aerospace business is in a great long-term position, forming half of a near-duopoly suppling a growing industry. Rolls has less scale and fewer structural advantages in, say, its marine business. Investors are going to judge Mr East and Rolls on the success of the aerospace business. Perhaps it would be better to focus the company on that area, too.

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