Earnings Transcript for RR.L - Q2 Fiscal Year 2021

Operator: Good day, and thank you for standing by. Welcome to the Rolls-Royce 2021 Half Year Results Conference Call. [Operator Instructions]. Please be advised that today's conference is being recorded. I would now like to turn the conference over to your presenter today, Isabel Green, Head of Investor Relations. Please go ahead.

Isabel Green: Hello, and welcome, everyone, to our 2021 half year results presentation. With me here today are Warren East, CEO; and Panos Kakoullis, our recently appointed CFO. Warren will begin today's presentation with an overview of our first half performance before handing over to Panos for a more detailed review of our financial results. Warren will then conclude with an update as we look out to the future. In all, they should take less than 40 minutes, leaving time at the end for your questions. Before we begin, please take note of the safe harbor statement on Slide 2. This results presentation contains forward-looking statements that involve risk and uncertainty, which may cause the actual results to differ materially. The full set of results materials can be downloaded from the Investor Relations section of our website. Thank you, and over to you, Warren.

Warren East: Thank you, Isabel. Hello, everyone, and thank you for joining us for our virtual half year results presentation. As Isabel mentioned, I'm very pleased to be joined today by our new CFO, Panos Kakoullis. Panos joined us in May, bringing with him a wealth of financial experience from over 30 years at Deloitte, and we're delighted to have you on board, Panos. Since our full year results, we've also appointed a new chair, Anita Frew, who joined the Board a month ago and will succeed Sir Ian Davis on the 1st of October. Anita is an experienced chair with in-depth experience from 2 decades of Board appointments, both in the U.K. and internationally, and we look forward to utilizing her skills for the benefit of the group. I'd also like to take this opportunity to thank Sir Ian Davis for his outstanding contribution and dedication to Rolls-Royce and his stamina. We wish him the very best for the future. This half, we also appointed Mike Manley as Non-Executive Director, and he joined the Board from the 1st of July. Mike has led businesses in the automotive sector in Europe, Asia and the U.S. and we value what his capability and experience will bring to us. This half, however, has not only been busy in terms of Board appointments. It's also been a great chance to get out on the road again. So here, on the slide, are a couple of examples. In late May, we opened our new testbed in Darby. Testbed 80 is the world's largest and smartest indoor aerospace testbed and covers both production and experimental testing requirements. And it was a major milestone for us. It's essentially a scientific instrument that's about the size of a cathedral with the most advanced testing technology we've ever used. We were delighted to have the right honorable Kwasi Kwarteng, Secretary of State for the Department of Business, Energy and Industrial Strategy to join us for the opening ceremony. I also recently joined U.K. rail operator Chiltern Railways as they celebrated their 25th anniversary, and they chose that event for the first journey on the public rail network for their new hybrid flex train. That was the result of a joint project that we've undertaken with Porterbrook, the U.K.'s largest owner of passenger rolling stock to bring hybrid trains to the U.K. network. The hybrid flex uses our MTU Hybrid-PowerPack, and Jens Gorcka [ph] with me in the picture is our engineer who's been babysitting it through several months of final trials and testing. This is just one of many examples of how our technology is playing a pivotal role in the transition to net zero. And we were absolutely delighted to be part of the groundbreaking team alongside Chiltern Railway and Porterbrook. And that hybrid flex is due to begin regular services in September. So now moving on and looking at our first half highlights. We've seen good progress and improvements in many areas across the group, and we're delivering on our commitments. Business performance is in line with our expectations and guidance, and we're moving forward with new business opportunities for future growth. In Civil Aerospace, we've made excellent progress with the restructuring program, and I'll go into that in a bit more depth in a moment. Business Aviation had a strong performance with flying activity returning to levels that we last saw in 2019, and that's also been the case for our large engines that are operated on domestic routes in both the U.S. and China. And in Defence, there has been demand for technology-led solutions with the U.S. Department of Defense and the U.K. and Ministry of Defense remaining completely committed to serious modernization and decarbonization of their fleets. In Power Systems, we've seen a recovery in our order intake and book-to-bill ratio with orders up 19% year-on-year, led by demand improvements in all our markets, but particularly in marine, governmental and power generation. In June, we went public with our net zero pathway, and we announced targets which set out our plan to develop new technologies, accelerate the take-up of sustainable fuels and drive step change improvements in fuel efficiency, and as well as decarbonizing our existing businesses. We're making disciplined investments in some exciting and potentially very significant new growth opportunities to lead the way to net zero power with our innovation and engineering excellence and grow the civil aero business into subsectors that are new for us. Turning to the next slide. Let's have a quick update on the progress that we've made on the restructuring program we announced 15 months ago. That's been focused on our Civil Aerospace business. We committed to a reduction of at least 9,000 Rolls across the group. To date, we've removed around 8,000, and we remain confident of reaching our target. That will be a reduction in civil aero of about 1/3 of management roles with commensurate reductions across staff functions, engineering and manufacturing. Our footprint rationalization is progressing well. We launched our large engine for assembly in Singapore as we consolidate that activity here in the U.K. We've moved equipment from Crosspointe in the U.S., and ahead of closing that facility, the machines were already up and running in Darby and contributing to improved productivity there. And when complete, we will have consolidated 11 sites down to 6, delivering productivity and operational cost benefits. And that builds on our investments in efficiency that we made previously, and we continued to roll out during 2020. So all in all, we're now achieving significant reductions in cycle times and overall productivity improvements. With CapEx reductions as well and operational cost improvements, we, therefore, remain on track to deliver cash cost savings of at least £1 billion in 2021 and over £1.3 billion of sustainable run rate savings by the end of 2022. Moving on to the next slide to summarize what this means for our financial performance. We've had a solid start to the year with improving cash flows and profits as expected. Our business split is looking more evenly balanced. Our underlying operating profit increased significantly at £307 million. And our free cash flow, though still in negative territory, was also markedly improved to just under 1.1 -- £1.2 billion of cash outflow for the half as we transition towards positive cash generation. Our restructuring program is delivering results. And as I said a moment ago, we expect to achieve over £1 billion in savings versus 2019 this year. This also makes us a leaner organization with a lower breakeven and much better operational gearing as growth resumes. And our disposal program is also progressing well towards our target of at least £2 billion in proceeds. With £7.5 billion of liquidity and no maturities before 2024, we're confident our position is strong and not dependent on the pace of Civil Aerospace recovery. And in addition, of course, we expect to generate funds as we execute on our disposals activity. So I'll now hand over to Panos for a more detailed review of our results.

Panos Kakoullis: Good morning, everybody, and thank you, Warren. I'm delighted to be here taking you all through my first set of results. I'm very excited to have joined Warren and the rest of the Rolls-Royce leadership team in helping the business achieve its true potential in the coming years. And what attracted me most is the opportunity to help fulfill that potential by very clearly delivering on the commitments we have made; by building a balanced, profitable and cash-generative business; by getting the balance sheet back into good shape; and by helping capture the demand and upside created by the energy transition. So let's just move on to the numbers. Our half year results, which we presented here on an underlying basis for the continuing businesses in the group, where they show a solid start to the year. Our restructuring program is very much on track and has helped to drive our return to profit in the period. Underlying revenue, that stayed steady, only 2% lower than the first half of 2020. And we've seen a much more balanced contribution from across the business units. Last year, well, the first quarter was relatively unaffected by the emerging pandemic, and as you'd expect, provides a challenging comparative whilst the second quarter last year was severely impacted. In fact, April 2020 was the low point for industry flying hours. This half year has been much less volatile despite some continued uncertainty with gradual recovery across the period. Operating profit was £307 million. This reflected the significant cost savings from the restructuring program that was largely focused on Civil Aerospace. We've also benefited from some favorable timing and the mix of activity in both Defence and Power Systems. In addition, last year's underlying operating loss of £1.6 billion included £1.2 billion of one-off charges in Civil Aerospace, mostly related to the impact of COVID-19. In the first half, we've incurred £174 million of financing costs. This primarily reflects the interest charges and facility fees on the debt and facilities that we secure to underpin our robust £7.5 billion liquidity position. That liquidity provides us with the confidence in our ability to withstand ongoing uncertainties around the pace of recovery in international travel. Financing costs in the prior period where they included a £1.5 billion one-off charge on closing the overhedged position. Turning now to Civil Aerospace. We've seen an overall improvement in performance driven by the significant cost actions we've taken. In addition, we're seeing a recovery in business aviation and domestic flying activity, where our engine flying hours have returned to 2019 levels during the period. Large engine long-term service agreement flying hours were 43% of the 2019 level, up from 34% in the second half of 2020. And this gradual upwards trend is still constrained by ongoing international travel restrictions and the uneven progress of vaccination programs around the world. During the period, we completed 284 large engine shop visits, 92 of which were major overhauls. Demand for new aircraft is expected to follow once existing fleets are well utilized. We delivered 100 large engines and 48 business jet engines in the first half, broadly in line with expectations. Civil revenue is £2.2 billion, some 13% lower than the comparative period. We've returned to operating profit at £39 million. We continue to focus very heavily on the areas within our control and have seen substantial sustainable cost benefits from our restructuring program. We are well on the way to reducing the size of our Civil Aerospace business cost base by around 1/3. Our Defence business, which is set out on the next slide, continues to perform well. Revenue of £1.7 billion is up 17% year-on-year. Operating profit is at £269 million, up from £210 million in the first half of 2020. We've seen continued demand and improved operational performance. This is driven by the continued resilience of our submarines business, coupled with early delivery of spare engines and higher spare parts sales. That mix, which delivers better margins, has historically been more second-half weighted. Now that favorable timing of mix in the first half is expected to result in a stronger first half versus second half performance. So our full year expectation is for broadly flat revenue and profit in Defence are unchanged. We have a strong order book, giving us confidence in that outlook with more than 70% cover for our expected sales in 2022. In Power Systems, which we set out on the next slide, revenues were broadly stable in the first half with an increase in services offset by a reduction in OE deliveries. Operating profit was £41 million, up from £33 million in the first half of 2020. We've seen a rise in higher-margin aftermarket spare parts, partly offset by low factory utilization on OE manufacturing. Now the other point of note here is that order intake was up 19% to £1.4 billion. This is led by improved demand across all of our end markets with particular focus in marine, governmental and power generation. Most of that recovery in OE order intake is expected to be realized as revenue over the next 6 to 12 months. We're also seeing interest in lower carbon solutions growing, and we continue to wisely focus our R&D investment on these products. Turning to the next slide. We've set out our funds flow. We saw a £1.2 billion cash outflow in the period from our continuing operations, which is a significant improvement on the £2.9 billion outflow last period. And just to help you understand it a little bit better, we've grouped this movement into 3 buckets. Firstly, we saw a trading improvement of around £1 billion. This looks through some of the noise of noncash items and was driven by a fundamental improvement in EBITDA, thanks in large part to our cost savings. Our capital expenditure was lower too, in line with planned spend as part of the restructuring. Secondly, our working capital outflow was £1.2 billion better than the first half of last year. This was mostly due to the non-repeat of the unwind of invoice factoring. Our concession balance fell by £239 million, which was lower than we planned for due to third-party deliveries moving out. Our strong liquidity position means we are not sensitive to the precise timing of the unwinding of these delayed concessions. Thirdly and finally, there are around £500 million of other headwinds year-on-year. Payments relating to the cash cost of closing out the overhedged position in 2020 increased in line with our previous disclosures. And you can see the detail of that in our supplementary slides. Interest and facility fees increased as guided with higher average debt and committed fees on facilities that strengthen our liquidity position. Pension cash costs were higher due to a one-off catch-up on a payment that was deferred from last year. Our free cash flow is continuing to improve. The combination of restructuring and recovering end markets is putting us on track to get back to positive cash generation. We remain confident we can deliver on our guidance for around £2 billion outflow for the current year. Turning now to our balance sheet on the next slide. We ended the period with net debt before leases of £3.1 billion, and we expect to end the year around £4 billion. To rebuild our balance sheet and get back to an investment-grade credit profile in the medium term, we are very focused on executing on our disposals program, together with tightly managed operational improvements in driving positive free cash generation from the business. A strong balance sheet is important to us. We will balance the pace of that rebuild with the investment opportunities across our portfolio to make sure that we maximize long-term return for our shareholders. Our liquidity position is strong at £7.5 billion. That is after repaying the EUR 750 million bond and the £300 million COVID corporate finance facility in the period. And we've recently extended the 2022 £1 billion unutilized loan facility to 2024. That means all of our debt maturities extend to at least 2024. We're confident in our liquidity position. It's strong, and we're not dependent on the pace of Civil Aerospace recovery. The disposals program is progressing well and we continue to target proceeds of at least £2 billion. We can't say much in detail here because of the ongoing processes, but we are having very constructive discussions and expect to achieve proceeds within the next 18 months. Early this year, our announced agreement to sell Bergen Engines was interrupted. We're now back on track, and you'll have seen the agreement that was announced yesterday. We're focused on getting the right results for our shareholders, and we will continue to do so in a measured way with plenty of liquidity, and there are no near-term pressures as we rebuild the balance sheet. We will focus on making sure that we achieve the right value for our investors. Moving on to outlook. We've made a good start to 2021, and our guidance for the full year is unchanged. We continue to expect to turn free cash flow positive sometime during the second half of this year. We also expect a full year free cash outflow of around £2 billion, which would represent an improvement of over £2 billion on 2020. This outlook was supported by continued resilience in Defence, growth in order intake in Power Systems, a gradual recovery in Civil Aerospace and our actions to drive down costs. As previously highlighted in our full year results in March, our guidance does, of course, remain sensitive to the timing of OE concession outflows on already delivered wide-body engines. Looking further ahead, we are confident that when border restrictions are lifted, the recovery of international travel will accelerate. The recovery we are already seeing in domestic aviation is encouraging. Free cash flow of at least £750 million is still achievable in a 12-month period when engine flying hours exceed 80% of 2019 levels. However, given the uncertain pace of recovery in international travel and looking at industry forecasts, it is unlikely that this will occur in 2022. We have a clear pathway back to a net cash position in the medium term. We have plenty of liquidity to manage the uncertain pace of the recovery in engine flying hours in the meantime. We're positive on the near-term opportunities in both Defence and Power Systems. The opportunities in our new areas of business, electricals and SMRs. We remain agile in our response to external factors and continue to deliver on our restructuring, rebuilding our balance sheet and investing in our future. Before I hand back to Warren, let me just give you 2 minutes on what I'm very much focused on going forward. I very clearly heard 3 things in meeting our investors

Warren East: Thank you, Panos, for the clarity there on our half year results, and thank you for the insight into the priorities that we've been discussing. I'm now going to turn to the future and the opportunities to further progress our business. So as many of you know, in June, we launched our net zero pathway and its targets. And although we operate in some of the hardest areas of the global economy to decarbonize, we showed our commitment to playing a fundamental role in meeting the challenge of climate change. Now that doesn't mean that we're stepping away from our traditional markets rather, that we're applying our engineering expertise and technology to find innovative and more sustainable solutions, which enable our customers to do things like continue flying without damaging the environment. At the same time, those solutions can generate additional growth opportunities for our business. On the left-hand side, you can see how a focused range of our interrelated technologies is applicable to decarbonize the complex critical systems in which we operate within a broad categories of energy, transport and to the built environment. So there's not time today to discuss that part of the slide in depth. The main graphic demonstrates our technology pathway to net zero in 3 broad categories with fuel efficiencies, new technologies and sustainable fuels, we can make a huge difference to Scope 3 greenhouse gas emissions by 2050. On the right-hand side, you can see compatibility with sustainable fuels plays a central role as we outline some of our net zero targets and commitments. These are also reflected in our remuneration policy. By 2023, we aim for all of our in-production commercial aero engines and our most popular diesel engines to be compatible with sustainable fuels. And by 2030, for all of our new products to be compatible with net zero operation. And in our Power Systems business, we aim to achieve a 35% reduction in lifetime emissions of new products sold. And by 2050, our ambition is for all of our products to be compatible with net zero operation. Now these are not simple goals. These will require collaboration across our businesses within Rolls-Royce as well as within a growing and evolving ecosystem. So looking to the future. Looking to our future strategy, it is about enhancing profitability in our existing businesses and developing growth opportunities triggered and enabled by the energy transition. The foundation is our large installed base. We're driving value in our existing portfolio through product enhancements that increase the efficiency of our products, so delivering more value to the customer, and also increasing durability in our civil business, for instance, leading to increased time on wing and therefore, increased profitability of our long-term service agreements. In Civil Aerospace, we're now entering a lower investment phase as our engine programs mature. Now our focus is on further productivity and efficiency gains, for instance, with increased use of digital technology. Meanwhile, we're ensuring compatibility of our civil and business aviation engines with sustainable aviation fuels, and our UltraFan architecture will deliver a further step change in efficiency, making it easier for our customers to adopt the more expensive SAFs in the long run. In Power Systems, we have a loyal customer base with replacement cycles that are regular and relatively predictable. And that gives us a great opportunity to work with those customers as we convert together, driving penetration of greener technology based around hydrogen, hybrid, and pure electric solutions. We're also exploring ways to expand our network further into newer growth regions globally. In Defence, our products have long life spans, which require us to provide upgrades and aftermarket services. We're also making investments in adjacent opportunities to expand our product portfolio further. And as mentioned at the full year results, we estimate over £7 billion of lifetime value from tenders that are related to the B-52 re-engining program and the U.S. Department of Defense Future Vertical Lift program. We're also working with our Defence customers on compatibility with sustainable fuels and opportunities for new and greener solutions. Now the energy transition also creates opportunity for new business. In Rolls-Royce Electrical, we're focused on the electrification of aviation. For us, that's about applying new technology to a market that we know very well indeed. For instance, safety and weight considerations, of which we have a thorough and deep understanding, are absolutely paramount. This offers some of the most exciting and innovative areas for growth outside of our current portfolio. We now have over 300 engineers working in our aerospace electrical business, a fourfold increase over the last 2 years. And since we last updated you at the full year results, we've made excellent progress on the development of our all electric propulsion systems for smaller aircraft. Now our commercial contract with vertical aerospace, left-hand picture on this slide, is progressing very well around the eVTOL vehicle, and they recently announced preorders for 1,000 aircraft with a potential value of over $4 billion. Vertical also recently announced their intention to list on the New York Stock Exchange. In another subsector, we announced a collaboration with Tecnam and Widerøe to cover the development and delivery of the zero-emissions P-Volt commuter aircraft, that's the middle picture on this slide, targeting an entry into service in the middle of the decade. We're also now testing a 2.5-megawatt power generation system used in hybrid electric propulsion. We saw a picture of that generator also on the front cover of this presentation. We'll talk more about Rolls-Royce electrical and for that matter, SMRs, our full year results, reflecting the way that we create focus on these areas internally in line with normal requirements for segmental reporting. Now it's not just about developing new technology for markets we know well. The energy transition is also an opportunity to take technology we know well and apply it to new markets in pursuit of growth, and that's what we're doing with SMRs. So turning to SMRs, or small modular reactors, it's not just about developing new technology for markets we know well. No, the energy transition is also an opportunity to take technology that we know very well and apply it to new markets in pursuit of growth, and that's what we're doing with SMRs. Firstly, SMRs it's important to note that as with Rolls-Royce electrical, any SMR revenue generated will be additive to the current portfolio. And the reason why we see so much potential in SMRs is because they're affordable for both on-grid and off-grid applications, providing zero carbon nonintermittent electricity, but they're also scalable to create large quantities of zero carbon power in a reasonable time frame, and it's increasingly clear that the world needs large-scale practical solutions fast. It's important to note that this isn't just about electricity for the grid. SMRs are ideal for the production of zero carbon hydrogen, synthetic aviation fuel, and other sustainable fuels so further enabling the production of clean energy for a range of different sectors and applications. And those countries around the world seek to comply with their legally binding carbon abatement targets, the stable supply of low-cost power becomes incredibly important. Our SMRs fit that need perfectly, creating a substantial global opportunity, even though our initial efforts, highlighted here in the time line on the slide, are focused on a U.K. grid-based application. We're particularly excited just now as we're in the process of forming a special purpose vehicle to take the program forward into the next stage of its development and we intend to enter the U.K. regulatory process this calendar year. And we'll step through the regulatory and policy processes in tandem, and we'll be targeting first power to the U.K. grid around 2030 with export orders following shortly thereafter. So let's summarize. I'll reiterate some of the key points for a takeaway. First and foremost, we're delivering on our financial priorities. Our restructuring is on track and delivering the results that we expected. Our disposal program is also progressing well towards our target of at least £2 billion in proceeds. Our cash flow and profitability are both showing significant improvement, and they're on track for our 2021 guidance. And we have the strong liquidity and clear pathway needed to get back to net positive cash and an investment-grade profile. Furthermore, as we look forward towards a low-carbon future, we will play a leading role in the transition to net zero carbon emissions by 2050. And that is through both decarbonization of our existing businesses and through multiple exciting growth opportunities for incremental business. And with that, I'd like to...

Operator: [Operator Instructions]. And the first question comes from the line from Andrew Gollan from Berenberg.

Andrew Gollan: Welcome, Panos. Two questions, please. First one is on the concession payments issue. So what is the expected benefit to free cash flow this year from the deferred payments on the Trent 1000? And compared to your assumption when you first guided to a free cash flow -- or free cash outflow of £2 billion? And I guess, effectively, is it just an offset to the lowered hopes engine flying hours? So that's the first question. Second question on the all fleet exposure. So pre-COVID, can you say what the percentage of engine flying hours were from Asia Pacific, ex-China? And given the slow progress of vaccinations there, what are your expectations for flight hours in that region in 2022, please?

Warren East: Yes. Okay. Panos...

Panos Kakoullis: I will do. Thank you. Thanks, Warren. Delighted to be here for my first set of results. And I guess, Andrew, what I would say when I look at full year guidance, and one of the things that struck me as I came into the business was this is a very broad-based group with 3 businesses in it. And there are a number of variables, both -- some in our control and some not in our control when we look at that full year guidance. We've reiterated the £2 billion outflow this year. There are definitely some ups and downs within that. You've mentioned concessions. There are some concessions that could go out and there are indeed some that could come back in. So there is some variability there. There is, I guess, a hedge within that around recovery in engine flying hours as well. So when I look across the whole group, we're comfortable in reiterating that guidance for this year, when I look at each of the variables, particularly the ones that are in our control. We've sort of highlighted the benefits that we're getting from the cost measures and the restructuring that we've already taken within the group. In terms of fleet exposure around those details. One thing I would highlight, and you've talked about China in particular, we have seen a recovery in domestic flying hours back to 2019 levels. And we know there is a significant part of that comes from Chinese domestic flight.

Warren East: Yes. I think the answer on the regional piece is that, yes, we do have an exposure in Asia and our big customers, Cathay and Singapore, clearly sort of facing reduction compared with where they were pre-COVID. As Panos said, we've been -- we can see the underlying demand in that region from the domestic travel in China. And it is just a question of how quickly orders can open, and that's a question of how quickly vaccination rates can get to a level to have significant proportions of the population vaccinated. And clearly, that's one of the contributory factors to what we're seeing as a very slow and gradual improvement in our overall engine flying hours. To answer specifically around the proportions, then it's approximately 20% of 2019 levels of engine flying hours that are exposed to international flights in that part of the world.

Andrew Gollan: If I could just follow up quickly on the concession payments answer. So if we simply break it down, I mean, at one point, we were talking around a target of £750 million free cash flow at 80% engine flying hours. And if we assume a sensitivity of £300 million or so for 10 points. So if we take step down on the engine flying hours assumption of 10 or 20 points, say, and then adding a headwind from concession payments catching up, does that indicate a scenario that we could be closer to breakeven free cash flow in 2022? Or is that just too simplistic?

Warren East: I think it's a bit too granular. And no, we're on a clear trajectory. I mean, last year's cash outflow, we know was over £4 billion. This year, we're sticking to a cash outflow of around £2 billion. We are sticking with our comments sort of going through to reaching cash positive at some stage during the second half of this year. And we'll be coming out with some specific guidance on cash for 2022 when we do our full year results. But we absolutely expect to be in positive cash territory by some margin.

Operator: The next question comes from the line from Robert Stallard from Vertical Research.

Robert Stallard: A couple from me. First of all, obviously, been a lot of reports of older aircraft being retired and their engines being retired as well. I was wondering if you've seen any impact as a result of parting out of older wide-body aircraft in the first half that was any different from what you saw in the second half of last year? And then on the business jet side, the Gulfstream G700 with the Pearl engine, are you seeing any additional challenges in getting that engine certified?

Warren East: Well, no particular changes to the patterns that we've seen on retirements of older aircraft in the first half of this year versus what we saw in the sort of in the second half of last year, really. I mean, and as far as our fleet is concerned, obviously, this impacts things like the RB211s and the Trent 800s. We've got specifics around Trent 900s on 380s, where some of those much larger aircraft have been parked. I think the thing looking forward for us is how quickly the A330s that have been parked return to service. And if we look there, we were coming into the pandemic, the sort of de facto market leader in terms of share. And that had been a relatively recent, i.e., sort of last 5 to 8 years phenomenon, and therefore, our engines are significantly newer. And so we would expect that the younger engines on the Rolls-Royce-powered A330s are the ones that will be favored when those A330s go back into service. On the Gulfstream and the new program that we're doing there, there are no particular extra challenges with certifying that engine at the moment.

Operator: The next question comes from the line from Jeremy Bragg from Redburn.

Jeremy Bragg: A couple of questions, please. First one on the breakeven rate for engine flight hours for free cash flow. So sorry, I'll put that a bit better. You're aiming to break even from a free cash flow perspective at some point in the second half of this year, and would you be able to state the engine flight hours required to do that, please? Second question on engine flight hours again. When do you think you will return to 2019 levels roughly? And that's obviously the net of retirement and deliveries. But I guess where I'm going here is you've taken 1/3 of cost out structurally in civil. So I'm just kind of curious to sort of see your view of when that recovery point is, please? And then the third question, if I may, please, around R&D. I note that you're spending 75% of gross R&D on sustainable technologies from now. Have you revised your assumptions on the self-funded R&D that you might spend over the next few years, please? And do you think -- do you still think there is a route to market for UltraFan given the lack of any new wide-body platforms?

Warren East: Yes. Righto, Panos is going to have the first question, and I'll...

Panos Kakoullis: Yes. Let me pick up on your first question around breakeven, Jeremy. I think as I mentioned earlier on, there are a number of ups and downs and variables that contribute to our results. Engine flight hours, as you rightly pointed out, is one of them. That's not one that's within our control. When we reiterated the guidance for this year, that £2 billion outflow and that positive at some point within the second half, we do look at all of those variables. The impact of the restructuring, some of the headwinds that we had in the first half of this year, which we've called out. When I put all of those in the mix, that's how we get confident that we will get through that breakeven rate this year. In terms of the forecast going forward, when do we get to 2019 levels? There are a lot of industry forecasts out there as to -- we can look at -- you can look out and rather than us adding our own. I'd encourage everyone to look at what the wider industry forecasts are.

Jeremy Bragg: On that though -- Panos, sorry to interrupt. I mean, we can look at the industry forecast, but you've always been quite assertive in the past that you've got a younger and better positioned fleet than the industry on average. So I'm guessing you must have your own separate view on that, please?

Panos Kakoullis: We do, and you can -- I think you can look historically how we have tracked against those industry forecasts. And I wouldn't expect us to be outlined with those industry forecasts.

Warren East: Yes. And again, industry forecasts are not very different from our own expectations of getting back to 2019 levels. And I think we've been fairly consistent that, that is some way off probably in the sort of 2024, maybe even 2025 time frame, we're going to see -- we will see a pickup when international travel opens. The demand that we're seeing where it has opened is a good indicator that there's plenty of demand there. So we can't be any more clairvoyant than anyone else. It's a few years away before we get back to 2019 levels. And that's an indication of the changed behavior that everybody talks about around travel. On R&D, then there's no big change to the absolute quantum that we've talked about before. I think what you are seeing in some of our commentary, though, is a tilt towards net zero and lower carbon, and an intention to push that up over the next several years to be 75% of our R&D investments and CapEx investments. And that is a process that we're going through at the moment, fairly disciplined capital allocation over the 5-year -- next 5-year period. Well, I think that's about it really on the answer.

Operator: The next question comes from the line from Ben Heelan from the Bank of America.

Benjamin Heelan: I had two. The first one, you highlighted you're making good progress on the disposals, and you said there's not much incremental you can give on those processes. I was wondering if you could give any indication about how you think about the impact to that £750 million of targeted free cash flow when you finally have disposed of those businesses? So that would be the first question. And then the second question, back on the concessions point because at the very beginning of the year, we were expecting a massive outflow, in particular, from 787 concessions. And I think Panos, you mentioned about £300 million outflow in H1. Are you expecting an outflow on 787 concessions in the second half of the year?

Panos Kakoullis: So I think your first question was around disposals and the impact of those disposal on free cash flow. It's not a significant impact. And you can see actually within our announcement where ITP is stripped out. So you can see that it's not a significant number. In terms of the concession payments, we are dependent on airframe of deliveries. And as you know that there are some well-documented uncertainties around that. We do still expect to see an outflow. Some could move out, some could move earlier, but we took those into consideration when we looked at full year outturn on the £2 billion outflow.

Operator: The next question comes from the line from David Perry from JPMorgan.

David Perry: I have two questions for you, if that's okay. First one is sort of philosophical on the balance sheet, which you've mentioned you want to improve. And you mentioned specifically the £3 billion of net debt is too high. But that's a very narrow definition of your net debt. It excludes operating leases and a lot of other financial liabilities that may or may not be treated as debt in your eyes. So I'd just be interested in how you see the balance sheet in and around? And then the second part of that question, if the ITP disposal happens, what do you think the next steps are, whether they can be wholly organic or other external actions might be needed? And then my second question, please, is you talked about wanting to simplify financial reporting. But I think your predecessors all had the same ambition as well. My view is probably the business model is just too complex. So the question for you is, are you comfortable with the LTSA business model? Or do you think Rolls needs to move away from that to achieve your goal of more simplified reporting?

Panos Kakoullis: I think on balance sheet, I think you heard in the comments that I made earlier on an ambition that we have in the medium term to get back to investment-grade credit profile. Lots of liquidity at present, so that £7.5 billion of liquidity that we've got at the moment means that we can do that in a measured way and make sure that we invest wisely at the same time just to pick up on one of Warren's comments earlier on. I recognize the point around other liabilities in the balance sheet. You consider all of those in and around when you're looking at getting back to that investment-grade credit profile. I think also it's going to be important as we look at the shape of the business going forward and as a more balanced business going forward. The gearing within the business may well look different to outlook in the past. So that's another consideration that you need to have. I think in terms of your second point around ITP disposal. I'd reiterate the point around liquidity. Liquidity is there. There is plenty of liquidity. We're not dependent on engine flying hours recovering. So I don't see the need for any other nonorganic I think, measures. In terms of financial reporting and your points around the business model, I'm comfortable with the business model. It's a smart business model. In fact, many businesses that I've been -- I've worked with in the past would love to have a business model where you have your customers being effectively so sticky and then you can work hard on making sure you deliver at a sensible cost. Does that -- I think your comment there was does that contribute to the complexity of financial reporting? No. I think spending time, and I have spent a lot of time now understanding the underlying business drivers. The underlying business drivers are straightforward once I spend some time. It's now how we make sure we translate that into a way that the outside world can understand in a more straightforward way.

David Perry: Well, good luck with it, and I look forward to meeting you next week.

Operator: The next question comes from the line from George Zhao from Bernstein.

George Zhao: We talked a lot about engine flying hours, so I want to focus on, I guess, on pricing. So on flight hour contracts, compared to the start of the year, have you seen any major changes in the trends around these prices when engines change hands or when new contracts are signed? And second question, a quick one. What proportion of the large engines are deployed on domestic routes today? And do you think that's sustainable?

Warren East: Yes. Engine -- or long-term service agreement pricing, our basic pricing model hasn't changed. Clearly, we have been engaged during this time where airlines have been restructuring, filing for bankruptcy and coming out of bankruptcy, restructuring, there's been new contracts to strike. And I would say there's been a mix there where we have -- and I think we've mentioned this in the previous results, we have been working with customers to accommodate some of their short-term financial challenges in the normal way of a commercial negotiation that generally involves something on the other side. And so that might manifest itself in terms of a period of lower per hour rate at given types of usage of an engine compensated by higher rates a little way down the road. And so sort of normal warp and weft of commercial negotiations have happened there. In terms of normally moving from one owner to a second owner then the principle that we quite often secure higher rates on that transition, that's actually held up remarkably well during this period. On your second question about domestic and large engines used on domestic. I mean, it's -- there's -- we have 2 areas. North America, we have some older engines that are used domestically. And in China, we see a lot of wide-bodies used domestically. And then case by case, different airlines have parts of their fleet with wide-body engines used domestically. And Japan is a good example of that with both ANA and JAL. And all in all, domestic use was about 10% of our total pre-COVID 2019. And obviously, it's a bit greater now as the sort of traditional long-range international stuff has fallen away. But I would see upward pressure because regions like China, in particular, and in Japan, we can see large numbers of people traveling short distances and airlines are using large wide-body jets to do that. And so I think the 10% is probably a floor and the 20% to 25% that we're seeing today is probably a bit too high for long-term sustainable and the answer is somewhere in between.

Panos Kakoullis: And George, just something I'd probably add on the pricing point, and you can see it in the half year numbers where we've got some long-term contract catch-ups, which are the result of some of those commercial negotiations. So I'm a big believer in us being rewarded for the value that we bring, and we recognize that within the long-term contracts when we've got that value. So you can see some of that upward gain around those commercial negotiations coming through there.

Operator: The next question comes from the line from Chris Hallam from Goldman Sachs.

Chris Hallam: So just three questions from me. Warren, perhaps first on strategy. There's no mention of hydrogen or absolute zero on your 2050 emission slide. And that's obviously a bit different to what some of the aircraft manufacturers are saying. So is that a different view of the future? Or do you expect to play a smaller role in propulsion if the industry does eventually partly transition to hydrogen? Second, perhaps, Panos, on the EFH payments. Can you give us an idea just on how predictable those payments are because I think most of them are done annually in relation to the coming year. So how difficult is it to firm up the level of those payments given the uncertainty on the shape of the recovery? And are customers paying on time? And then finally, just on free cash flow phasing. You've said you'll move to positive free cash flow at some point in H2. There's obviously a lot of seasonality in the business, but there's also the gradual EFH recovery and the savings benefits is kicking in. So should we sort of be assuming that H1 next year is better than H2 this year and then H2 '22 is better than H1 '22?

Warren East: Okay. Chris, let me just answer your first question. Also, have a go at that second one. So I think the simple answer is hydrogen is included in inverters new technologies on that slide. I did mention in the presentation that we haven't really got time this morning to discuss that slide in a lot of detail. And there is a huge amount of detail behind that slide. Hydrogen will play its part in lots of different sectors. It's probably less likely to play a part in long distance international travel than there'll be shorter distance, smaller airplane place for hydrogen to play, that's what we're currently believing. But it's very much part of our piece, and you should have a look at our net zero report that's on the internet that we launched a few weeks ago.

Panos Kakoullis: And then in your other two questions, on engine flying hour payments, no particular concerns around the customers being able to pay. They're paying on time as we expect. In terms of the pattern of those, mostly the payments are based on hours flown. Occasionally, some pay based on shop visits. But again, that is relatively predictable, subject to engine flying hours actually being flown as we said earlier on. In terms of your seasonality point, you're right. We maintain cash flow positive as we go through the second half of this year at some point. When you're looking at next year, think of that upward trend continuing for the course of the whole year. So the full year impact of the restructuring benefits coming through, the £1.3 billion run rate we've talked about, the recovery in engine flying hours. Power Systems, we've called out the increase in the order book, that starts turning into revenue and then cash as you go through next year. Defence remains resilient. And the underlying seasonality that you referred to that you've seen over past years, you should expect that to remain with the second half of the year being the more positive compared to the first half of the year.

Operator: The next question comes from the line from Andrew Humphrey from Morgan Stanley.

Andrew Humphrey: I've got a couple, if I may. One is on Civil Aerospace profitability in the first 6 months. Panos, you mentioned positive contract catch-ups in the period, but it also looked to me as though the underlying performance -- the clean performance on civil aero gross profit stability was stronger than maybe it was reflected in consensus. So I wanted to ask if there was anything specific in the mix either in terms of engines coming in for service or in terms of customers that would flatten that in this period? Secondly, maybe one for Warren. We've obviously had confirmation of an A350 freighter entry into service 2025. I wanted to ask you about how you're assessing the opportunity there in terms of any additional capacity you may need to make available?

Panos Kakoullis: Yes. So let me pick up on the Civil Aerospace profitability. So nothing specific in the mix to call out there around the underlying. The other point I'm sort of curious about is around contract catch-ups. So sometimes when I see commentary on them, they're sort of viewed as something to ignore or to overlook. The reason those contract catch-ups are there, and they're positive contract catch-up is twofold. One, I've already mentioned. So when commercial negotiations, we've been robust, and we see that being baked in as a benefit. So it means the long-term contract as a whole is going to have a greater margin because of that, and this is the catch-up to recognize that. And the other element that we've called out there is the cost savings that are now baked in. So we plan for cost savings, but we don't recognize them until we are sure of them and they start to flow through. And I think particularly within business aviation, those catch-ups are going through. So I recognize that we're looking at a 6-month period, but I tend to look at long-term contracts as long-term contracts, and what's their -- what's happening to the margin of those contracts over their life, and those catch-ups represent an increase in margin over those.

Warren East: And to your question on the A350 freighter. Obviously, that announcement for Airbus has been a little welcoming, and we're delighted with that. It's a very welcome pull forward as far as we're concerned of growth in demand for our engines. We won't need to worry about any incremental capacity. I mean, don't forget, we have -- essentially have capacity for about 500 new large engines per annum, and that's the rate that we were delivering at in 2019. Yes, we've been doing some consolidation of our facilities, but it's very much a consolidation activity. And we would expect to be able to scale up again later in the decade when demand returns without having to move on and open new factories and that sort of thing because of the huge productivity improvements that have been baked in. So we don't need to invest in any additional capacity. But the A350 freighter is a welcome sign.

Operator: Your next question comes from the line from Nick Cunningham from Agency Partners.

Nick Cunningham: Yes, I'm having dealt with a lot of detail, perhaps one could ask a more general question looking forward. And I think thinking past the crisis, you wanted to reduce your costs to the point that Rolls-Royce became -- Rolls-Royce civil aero engines became intrinsically adequately profitable, which it hasn't been in the past. And so what I wanted to ask is, what would adequately profitable look like? And how would one measure that? And given what you know about your costs and future overhauls and so on, would -- when we get to, say, 2024, 2025, we get to 100% of 2019 EFH, would you then be adequately profitable on that basis? And then a second longer-term question, slightly longer even than that, sustainable fuel, I think, is a sort of linchpin of your plan for zero carbon and clearly, very important and this enables you to stick with your existing technologies to a great extent. What's your assumption about how competitive SAF can be relative to fossil fuel costs? And do you have to assume some tax, if you like, concessions for SAF and a carbon tax on hydrocarbon fuels in order to make that work?

Warren East: Yes. Well, in terms of our ambition for profitability in civil, then -- so we've been working on improvements in productivity in civil and cost out in civil for a while. The restructuring that we've been through the process of implementing over the last 12 months. By the way, we have a little bit further to go yet because this consolidation from -- of 11 sites going down to 6, that's not actually complete until the back end of next year and possibly even a little into 2023 for some of those sites. So we're not quite done yet, but the heavy lifting has been done on that. And then we will have -- and I've referred to it as -- in the presentation, as a better breakeven and better gearing as demand returns and that will, we believe, take us into a competitive zone in terms of profitability for our civil large engine business. And that would be certainly in the mid-teens. As far as SAFs are concerned, looking forward to net zero, this isn't a Rolls-Royce thing. This is an industry thing. For long-distance international travel, the industry doesn't see a technology solution that's appropriate other than synthetic aviation fuel. For shorter distance, smaller aircraft, then full electrification, hybrids, hydrogen, all of these sorts of alternative technologies have their role to play. But in the long-distance wide-body space, then it's going to be SAF. Now the good news is, of course, that things like our small modular nuclear reactors are very useful in terms of zero carbon electricity because large-scale SAF production requires large-scale green electricity. And that electricity can also be used for things like hydrogen, as I mentioned. The cost of SAF at scale, we believe, will be approximately twice the fossil fuel equivalent that fossil fuel has at the moment. Now that's a little bit of a sort of industry guess. That isn't a Rolls-Royce guess. It's an industry expectation at the moment. And that's why it's important that we introduce things like the UltraFan new architecture to have a step function in efficiency to help our airline customers be able to adopt that. And you might have seen some of the airlines working on their cost projections and how they've been deeming that SAF will be affordable.

Panos Kakoullis: And Nick, I probably just to add on the first point around profitability. Again, coming in, I look across at a better balanced group now, and I look at Defence and Power Systems and the opportunities there, the resilience and opportunities from energy transition and push hard around what those margins should be to be competitive within the marketplace. So I don't just look at civil. I want to make sure that we are looking across the whole business and shining a light across each of the businesses.

Nick Cunningham: And very full answers for which I'm grateful. But just to clarify on the, if you like, adequate profitability, mid-teens would apply to civil and to the group? Or would you say a mix -- is there an intrinsic mix of margin across the different businesses?

Panos Kakoullis: There's going to be a mix.

Operator: The next question comes from the line from Harry Breach from Stifel.

Harry Breach: It's Harry Breach here. Could I possibly just ask maybe 3 questions, if I could. Just back in March, I think you guys said you were expecting large engine shop visits. This year, I think, about 240 and then 400 next year. I guess over the last few years, those large engine shop visits have been a key indicator for us to try and model the business. So it's very helpful if we can have some sense of where they're heading. You've done 92 in the first half. I guess that leaves about 148 in the second. Is 240 still the expectation for this year and 400 next year? And maybe secondly, guys, we almost don't talk about time and materials aftermarket revenue at civil anymore. But just trying to look at the financials, it looks as if looking at the analysis of aftermarket revenue is recognized at a point in time for civil and looks as if it was down really quite steeply. I think £193 million is the number, if I've read it correctly, for the first half of '21 versus £746 million in the first half of last year. Can you help me -- maybe I've made another silly mistake, but could you help me to understand whether T&M has fallen significantly and what the sort of drivers are? And then finally, Warren, I guess, again, in the past, pre-COVID, we used to talk about when across the portfolio, original equipment unit losses would get through breakeven. Obviously, last year was heavily disrupted with a lot of rescheduling of production plans, and it wasn't a meaningful number. But can you give us some idea, Warren, about when you think we'll get through breakeven in terms of original equipment unit losses?

Warren East: Okay. I think we're going to have to answer these questions quite quickly.

Panos Kakoullis: Yes, let me just rattle through the first couple. I think, shop visits. It's obviously dependent on what happens on engine flying hours. So one that's harder to predict, but a little bit of a shift to the right around that. On timing materials, you're right, the fall is there, but there are again, lower -- less flying is going on, which means fewer of T&M type shop visits. Also, V2500 is a little bit lower around that.

Warren East: On the OEM breakeven point, yes, you're right. Disruption caused last year made it very difficult for us to continue sort of reporting that because obviously, there were large chunks of unrecovered cost. We will try to provide some guidance on that with the full year results. But certainly, our ambitions haven't changed and it's a question of volume. And of course, the restructuring will give us a significant tailwind in that regard.

Operator: The next question comes from the line from Charles Armitage from Citi.

Charles Armitage: A couple of quick ones. First of all, going back to Jeremy's question, wide-body market flying hours will recover whenever it does. But if you look at -- compare Rolls-Royce to the overall market, you've got a younger fleet, you're delivering more engines than you have compared with your market share on the fleet, and you've got a few old engines to retire. So that should grow faster. But on the other hand, you don't have the freighter exposure. So do you feel that Rolls wide -- large engine will grow -- will recover faster or slower than the widebody market as a whole? That's my first question.

Warren East: Yes. Well, it's a slightly loaded question. And the answer is the correlation that we saw last year between what's going on in the industry at large and recovery of usage of some of our engines, I think that holds going forward. It holds as far as things like our XWB are concerned, very pleasing utilization of some of those. You're right in terms of freighters, older aircraft. We are now seeing freighter conversions, passenger freighter conversions going on with A330s and so on. And again, because our engines are the younger models of those aircraft, then I think there is a favorable tailwind for us. And obviously, as I said in answer to an earlier question, we're delighted with the Airbus freighter -- dedicated freighter announcement. So broadly correct, the -- we would expect to be on the positive side of a recovery trajectory.

Charles Armitage: Great. Second question is EFH pricing. As I understand it, there's a matrix dependent on how far the routes are and whether they're hot and high, et cetera. Now as I understand that the stage length has come down, which would imply that the price per hour should be going up, yet we haven't heard anything about that. Is that a -- one of these long-term benefit in kinds or trading short term for the long term? Or is it not coming through? Or what's happening on that one?

Warren East: Yes. I think intrinsically, you're absolutely correct. It's quite hard to see that coming through in the overall numbers. We'll take the point on and see if we can throw some color on that with our full year results. But you're absolutely correct in terms of the principles that you outlined there.

Charles Armitage: Okay. And the final question is, we were sort of agonizing over this in 2019 and it seems to be rather less important in the whole scheme of things. But the Trent 1000 10 HPT was due to be -- the fix was due to be certified around midyear '21. So a £24 million increase in the provision. What's happening on that one?

Warren East: Yes. I think -- well, as we sort of indicated at our full year results, that certification has been pushed out. We don't have that certification yet. We are expecting that certification before the end of this year. But in the detail, the FAA and their relationship with Boeing, they've had a lot of other things to do, basically. And certifying our Trent 1000 blades is a bit lower down on their priorities than it was when we made our original estimate. We are confident in the parts and we're already making the new parts to fit when we do the overhauls just as soon as that certification happens and we're expecting it just before the end of this year, probably.

Charles Armitage: So from the Rolls-Royce perspective, it's the -- the technology work is done...

Warren East: Yes. It's all complete and we're in the queue as it were.

Operator: And our last telephone question comes from the line -- from Celine Fornaro from UBS.

Celine Fornaro: I'll have two, if I may. The first one would be trying to reconcile the second half of last year performance with the first half of this year performance. I'm trying to reconcile a little bit or maybe you could help me with that on the profit reach on the cash bridge because clearly, there is a strong improvement in the profit even if I put on the side, the £166 million and TSA contract recognition. But we don't really see that from a cash point of view. So maybe you could help us on the moving parts, understanding what is the restructuring contribution or the flying hours, or [indiscernible] and other things there? And then my second question would be regarding something you touched about. But yes, certainly encouraging H1 performance. But how do you think you compare yourself versus other industrial businesses who have had really strong H1 results. And so what could you change in Power Systems there? Or is it very heavy H2 [indiscernible]

Panos Kakoullis: On the first one, I suggest we take that one off-line, and we can take you through that outside of the call.

Warren East: And on the second one around Power Systems and some of the Power Systems competitors, I think you have to look in -- at the power categories that -- where those competitors have seen a strong rebound in the first half, and we're not actually in those power categories, which is why we haven't seen it in Power Systems. But what we have seen is a near 20% uptick in orders. And so we are seeing a rebound, but it's probably 6 months or so behind that -- some of those competitors you've seen.

Celine Fornaro: But in terms of the profitability of 3.5%?

Warren East: Well, I mean, that is a result of a whole lot of factors. And it's basically less revenue actually going through with the same cost. And obviously, because of some of those competitors, as I said, have seen the impact some 6 months or so ahead, then that will be reflected in higher profitability.

Panos Kakoullis: And I think you have seen in the past, it's a second half-weighted business. So margins we're expecting for the year are in line with our previous expectations.

Isabel Green: Thank you, Celine. And Isabel here. I've got one question that came through on the webcast just to finish up with, which is for you, Panos, and it's from Rory Smith at Investec. He's asking if we can talk a little bit more about the steps you've already taken to simplify reporting and what you expect may change in terms of KPIs that we produce and how we're going to improve our reporting going forward?

Panos Kakoullis: I think early days at this stage. What we've tried to do with this half is trying to take a little bit out of the noise between statutory reporting and underlying reporting. So you can see that that's been simplified. Then looking at the underlying business drivers, how we get a better understanding of how those flow through the financials, and there is more to come, particularly as we look at hedging and foreign exchange going forward. But that's a bit more of a medium-term project.

Isabel Green: Thanks, Panos. And so back to Warren to close the call. Thank you, everyone, for their questions today.

Warren East: Yes. Thank you all. Just the quick summary to take away is that we're delivering on commitments made here. Restructuring is on track, the disposals program is going well, we are seeing significant improvements in profitability and our cash flow, and again, a continued position of strong liquidity and that journey to net cash in the medium term. And that's enabling us to have some confidence around the disciplined investments that we're making in the future in our low-carbon businesses, which will be incremental around -- incremental to our business as it exists today. So with that, I'll finish, and we'll be back to tell you about our full year results in due course.

Operator: Thank you. And that does conclude the conference for today. Thank you all for participating. You may now disconnect.