Earnings Transcript for RR.L - Q4 Fiscal Year 2020

Operator: Thank you for standing by, and welcome to the Rolls-Royce 2020 Full Year Results. [Operator Instructions]. I must advise you that your conference is being recorded today, Thursday, the 11th of March 2021. I would now like to hand over to the speaker for today, Isabel Green, Head of Investor Relations. Please go ahead.

Isabel Green: Welcome, everyone, to our 2020 full year results presentation. With me today are Warren East, CEO; and for his final results with us, Stephen Daintith, CFO. Also with us today is our Deputy CFO, Ben Fidler. We'll start the presentation shortly with an introduction from Warren, followed by a more detailed review of results by Stephen; and lastly, returning to Warren for an update on our outlook and strategy. In all, this should take about 40 minutes, leaving plenty of time at the end for Q&A. Before I hand over to Warren, please take note of the safe harbor statement on Slide 2. This results presentation contains forward-looking statements that involve risks and uncertainty that may cause actual results or developments to differ materially. A full set of results materials can be downloaded from our website. Thank you, and over to you, Warren.

Warren East: Good morning, everyone, and thank you for joining us. Now before we look at our performance in detail, I'm going to reflect for a moment on the extraordinary and unprecedented year in 2020. And you can see from the images on the top of the slide there about just how devastating it was for our sector. It was also devastating for many people. It was a year where our colleagues made many personal sacrifices. And despite all the challenges, they still managed to dig deep to find the solutions to help keep our company strong for the future. And I'm very mindful of the fact that around 7,000 of our colleagues, some of whom have worked with Rolls-Royce for many years, have left us as we took actions to restructure and protect our business. And I thank all of those colleagues, both past and present, for their contributions, their diligence and their hard work. Looking at the images on this slide, I'm particularly proud of the practical support that our people have given to the communities in which we work, doing things such as making face shields and volunteering to help those in need. As a company, we also endeavored to give back to our community. We launched the Emergent Alliance, and that's now growing to more than 140 members. And we've worked together there with the community using data analytics to assist economic recovery. Here in the U.K., we also joined the ventilator program, and we've been providing home learning and STEM materials to encourage online learning for young engineers and inventors of the future. Finally, of course, I must thank our investors and our lenders who helped us and gave us additional liquidity to weather this crisis. So as we move forward, preparing for the recovery and investing for the future, we're very aware of the responsibility that we now have to honor the support we've received from all of our stakeholders by delivering on commitments that we've made and achieving those goals. So now moving on to group performance. I'm on Slide 5. When COVID arrived early in 2020, it had an immediate and very material impact on our business. You remember, we came into 2020 with great positive momentum, and that momentum that we had at the start of the year was overtaken. And in response, we took decisive and effective actions to protect our people and protect our business. We introduced new ways of working to protect our colleagues, and that enabled us to maintain operations throughout with minimal disruption. We took mitigating actions that save more than £1 billion in cash. We secured more than £7 billion of additional liquidity and to secure the future. And we embarked on a very large restructuring, the largest restructuring in our history, to fundamentally change the economics of our Civil Aerospace business, and that's going to save more than £1.3 billion of annual costs on an ongoing basis. We've also committed to rebuild our balance sheet, which is supported by a disposal program, where we're targeting more than £2 billion from disposal by 2022. And despite the enormous pressure on cash and the cost reductions, however, we managed to continue to investment in sustainable, low-carbon solutions for the future. And I'm going to come back and say much more about that later in this presentation. We're now looking at the business highlights for 2020. I mean the impact of COVID on our business, you can see on the right-hand side of the chart different businesses affected in different ways. The impact of COVID was most acutely felt in our Civil Aerospace business with engine flying hours reducing sharply in April to less than 20% of 2019 levels. And as the year progressed, those flying hours gradually recovered. Now while the rollout of vaccines and testing gives us good reason to look forward to the recovery, the impact on our industry is severe, and OE demand is expected to remain low for several years. On large engines on wide-body aircraft, that's where we're most exposed to the downturn. International and business travel particularly was affected, and that's likely to recover slowly. Regional and narrow-body flights have been marginally less impacted with fewer cross-border routes. Business aviation was relatively resilient, and that was helped initially by repatriation flights at the start of lockdowns and, of course, much less exposed customer base. We've made good progress on our fundamental restructuring program in civil, around 5,500 of the roles removed so far from our business from the Civil Aerospace and that will, of course, give us permanent cost efficiencies and help reshape the economics of our business for the longer term. And I'll talk more about that later in this presentation. Despite the challenges, we've managed to continue to serve our customers, we've managed to design and manufacture solutions and invest in new technology. We've achieved our target of eliminating aircraft on ground due to the Trent 1000 durability fixes. And we've now got enough parts and MRO capacity there on Trent 1000 to avoid a recurrence of any customer inconvenience, even if miraculously all travel restrictions were lifted today. In ITP Aero, we've seen, of course, similar market dynamics because Civil Aviation accounts for about 70% of ITP revenues and Defence activities in ITP contributing the rest. That performed relatively resiliently. Power Systems was less affected than our Civil Aerospace, but still quite affected by what happened, but it has a number of end markets, each with its own dynamics and that has helped to balance the business performance in Power Systems. Government end markets, for instance, were the most resilient, whereas industrial and marine suffered from the impact of lower economic activity and lockdown restrictions. Our strategy in Power Systems to grow in China also helped the overall performance of that business with structural growth and market share gains continuing. And our solutions to support and enable the transition to lower-carbon power have had a good year driven by investments in batteries, hydrogen fuel cells and hybrid systems. And moving to the bottom of the slide, Defence. Defence had a good year because our government customers remained committed to the programs that we're delivering, and our order book remains strong. And this year has -- or 2020 has been a real reminder of why the Defence business is an important one for our group, delivering profit growth even in what turned out to be the most challenging of years across the rest of our business. Now I'll hand over to Stephen to talk more about our financial performance.

Stephen Daintith: Thanks, Warren, and good morning, everybody. So our full year 2020 results were severely impacted by COVID, as Warren has just outlined. In addition to the trading impact, there were a number of large onetime charges in our underlying and reported results. Now they're shown here on this particular slide, Slide 8. These charges were mostly incurred in the first half of the year when the outlook suddenly deteriorated. Group revenues declined by more than 20%. This reflected the drop in activity in Civil Aerospace, ITP Aero and Power Systems but also the impact of a £1.1 billion negative catch-up charge on our Civil Aerospace long-term service agreements. This related to changes in the outlook on our long-term contracts as a result of COVID, which led to the derecognition of some of the revenue that has been booked in prior years. Now we had a gross loss of £512 million in 2020. This included £1.3 billion of onetime charges, most notably the impact of the contract catch-ups that I've just talked about, although the gross profit charge was slightly lower than the revenue impact after taking risk and revenue share partners into account. In addition, we took a £213 million charge related to onerous or loss-making contracts. Now we don't have many of these, and they are mostly related to the Trent 900 engines on the Airbus A380s. As the largest passenger plane in service, these have been particularly affected by the fall in passenger demand. It's been a very tough year for everyone in our industry. A number of our customers have had challenges with their liquidity and financial stability. We have responded commercially with relaxations of certain terms and conditions, and we're keeping a close watch on the customer credit risk. Prudence requires that in some cases we provide for specific customer credit risk, which is why we have taken an £86 million charge in this respect. The final large charge on our underlying results is the £1.7 billion financing cost charge related to our hedge book. Our U.S. dollar hedge book provides cover for transactional currency risk because our dollar receipts usually exceed our dollar costs. The impact of COVID on our future forecast left us significantly overhedged and so in 2020 and early 2021, reduced the hedge book at a cost of £1.7 billion spread over the next 6 years. Now you can see on this slide the business unit performance in more detail. As Warren has already talked about the market drivers of our performance, so I won't need to cover those again. What you can see here is the scale of the impact of the drop in performance in Civil Aerospace has had on the group as well as the impact of the COVID-related onetime charges, which make up most of the loss. Power Systems, Defence and ITP Aero all contributed positively to operating performance, albeit only Defence achieved year-on-year growth, up 8% on 2019. Now this next slide details the successful mitigating actions we took this year to help protect our financial and liquidity position. We've had a laser-like focus on cash costs, culminating in year savings of more than £1 billion compared to our plan at the start of the year. The largest savings of around £500 million came from a reduction in pay and benefits. Now this was a result of 3 key things

Warren East: Thank you, Stephen. Okay. Let's move on. Now, as I said before, this has been an unprecedented time. We have faced up to the challenges with decisive and effective actions to take control of the things we can control and manage the things that we can't control. And within that framework, we have 3 clear priorities as we look forward. First of all, restoring our financial performance, then thinking about how we maximize value from our existing capabilities for the medium term and, looking further forward, how we deliver the science-led innovation in sustainable power that's going to take us forward into the longer term, and I'm going to take each one of these in turn. So let's start with our financial performance and how that changes. The -- we'll step back for a moment and look at the global economy. The impact of COVID on the global economy has been greater than any other event in recent history. You can see from the chart on the top right here. Nonetheless, there is cause to be optimistic about a V-shaped recovery, and that's underpinned by the efficacy of vaccines and the decline of infections in locations where vaccinations and testing have been rolled out. The data is -- initial data is very encouraging. The pace and timing for opening up borders, however, remains uncertain today, but it's clear from our airline customers that there is significant pent-up demand from consumers for flights just as soon as they're able to resume. And this could be accelerated by vaccine passports, air bridges or other risk-based approaches between countries with low levels of infection. Now in Civil Aerospace, there is, as you know, a historic correlation between GDP and flying with growth in passenger miles increasing at around 1.5x the pace of economic growth. And there's also a strong link between the development of the country's economy and the penetration of flights per person. And as a result, fast-growing economies with low levels of air travel fuel the long-term expected growth trends for our industry in the coming decades. And this makes it hugely important that we develop the right low-carbon solutions that will support these economies to develop cleanly and sustainably, and I'm going to elaborate more on that in future. Now Power Systems is also a GDP-plus business. But unlike Aerospace, it doesn't have particular issues around opening up of travel corridors and government-to-government agreements. And so we expect the V-shaped recovery in GDP to result in a faster recovery of revenues and profits. Defence, as I said earlier, has been less impacted by the crisis. It's also less impacted on an ongoing basis by fluctuations in GDP because government allocations are driven more by the need for investment based on geopolitical risk. And actually, we don't see that geopolitical risk changing anytime in the near future. But of course, there will be pressure or likely to be pressure at any rate on total government budgets in coming years as they seek to repair the economic and social damage that has been caused by COVID. So moving on to Slide 19, talking about Defence and Power Systems. I'll start there with a little more detail. Power Systems and Defence have been the bedrock of support for us this year, and they've contributed over half our revenues and generated both profit and cash for the group. Power Systems provides the power for industrial and agricultural growth as well as travel and infrastructure, and reliable power is critical for continuity of services, and our microgrids and backup power solutions can provide that. And as we see economies reopen and get back to business, so we expect our customers' capital expenditure cycle to accelerate, and that will drive a sharp recovery in demand for our OE and for aftermarket services. And so we see our Power Systems business returning to 2019 revenue levels by 2022, along with a margin recovery back to double-digit levels. And that is helped by structural growth in China, that I've mentioned before, and increased pace of development of low-carbon solutions as well as the general recovery from COVID. In Defence, we have a stable outlook. We have a strong order book. We're working continuously in that business to offset inflation and pricing pressure with savings and operational efficiencies. And we think that we're in a good position to benefit from future program opportunities as they emerge. So now let's look at Civil Aerospace on Slide 20. Clearly, the pace and timing of recovery in engine flying hours remains uncertain, but the progress on vaccines and testing is encouraging. At the start of the year, in January, we updated our expectations for 2021 to reflect the challenges that the world is seeing from new virus variants and new national lockdowns, and our view of a recovery in 2021, we modified, and this is particularly about the Rolls-Royce fleet, by the way, that we modified to an average of around 55% of 2019 levels, and that remains unchanged as we sit here today. Today, activity is actually below that level. But based on third-party projections and conversations with our own customers, we expect the recovery to pick up in the second half of the year as flights fill up and the airlines open more routes. And this recovery is likely, of course, to be led by short-haul leisure demand, and that will be followed by business trips and long-haul journeys. Now turning to our expectations for engine flying hours in 2022. We're now expecting around 80% average flying hours in 2022 compared to 2019, and that's different from the 90% we talked about previously. The impact of this downward revision on our £750 million cash target has been mitigated by additional management actions and our latest view on certain cash movements. We've also refreshed our plausible and severe downside scenario to make sure we're well prepared should the recovery take a little longer. Full details of our scenarios are included in the press release. But in summary, we see a reasonable worst-case of around 45% of 2019 levels in 2021, that's flat on 2020, but it's a bit higher than the levels we're seeing today, and approximately 70% of 2019 in 2022. So we continue to see a disparity between the different engine programs, the chart on the top right-hand side slide, and you can see that shows that the newer, more efficient aircraft and engines are the ones that are recovering faster than the more mature ones. And that's, of course, driven by the economics for airlines as they look to minimize their operating costs. And it's also driven as well by the geographic mix and customer concentrations of our fleet. You can see our Trent XWB engines have been the fastest to recover. They've already reached around 60% of prior year flying hours by the end of 2020, and that's followed closely by the fleet of Trent 1000. One of the bright spots for the whole industry last year was the winning combination of our Trent XWB engine on the Airbus A350. This is the most fuel-efficient wide-body aircraft in the world and it has versatility to serve both long-haul and short-haul routes. Now we're already exclusive on the A350-1000 variant of the aircraft, and we are extending our position, our exclusive position, on the A350-900 variant, and that accounts for the bulk of the A350 fleet, and that extension has agreed with Airbus out to 2030. Now that's in line with the development time line for our next-generation UltraFan engine program. And just to remind you, by the way, that we're also the exclusive engine provider for the A330neo with the Trent 7000. So Slide 21. I talked so far about recovery factors that we can't control, engine flying hours, behavior of airlines and the like. Now I'm going to talk about things that we can control. We were quick to recognize the need to self-help actions to control our cost base and position our business for the future last year. And in May, we announced a fundamental restructuring program, the largest we've ever undertaken. The impact on our people of a change program at this scale cannot be underestimated, and we didn't -- certainly did not take this decision lightly. We're consulting with colleagues on the proposed actions. We're working with unions and employee representatives to try to limit the number of compulsory redundancies and protect as many livelihoods as we can. We've increased support for mental health and well-being, and we're helping those that are affected by redundancy to find alternative roles, sometimes elsewhere in Rolls-Royce, sometimes outside of the company. But the outcome we're targeting is clear. We need to restructure our cost base and eliminate the under-recoveries and set up the framework that will enable us to recover strongly when activity levels return. So we've set the target to achieve annualized pretax savings of more than £1.3 billion by the end of 2022. And our plan for this includes the removal of more than 9,000 roles, and most of those are in our Civil Aerospace business. It includes consolidation of our operational footprint and cost discipline right across the business. And we're also looking to keep our capital expenditure low, and we're aiming to be at the better end of our peer group range of 3% to 4% of revenues in that respect. Now we made a strong start in 2020. In 2020, around 7,000 roles were removed across the business, mostly through our voluntary severance programs, but also as a result of hiring freezes via contractors, some compulsory redundancies. We also began consultations to consolidate the major Civil Aerospace operating sites, consolidating 11 sites down to 5, with activities being moved to the most productive cost-effective hubs and a reduction in the duplication of work in multiple locations. We're engaging with all the stakeholders to make sure that our actions are both fair and effective. Now let's have a look at the economics. Changes are fundamentally altering the economics of our Civil Aerospace business, and that's shown here on Slide 22. The majority of our cost savings are targeting fixed costs in our Civil Aerospace business. We're reducing headcount by approximately 1/3, and we're looking to lock in substantial savings from those site consolidations and efficiency improvements. And on top of that, most of the planned group capital expenditure savings are also in Civil Aerospace. And there, we have a reduction of more than 50% versus the 2019 levels. And that's, of course, helped by the growing maturity of our newest engine program, so some of that CapEx was going to reduce anyway. At the same time, we're seeing our variable costs reduce with load, but we're also pushing those variable costs even further. We're challenging ourselves to achieve better pricing and engineer greater efficiency to reduce per-unit cost and waste. It really is a fundamental transformation of the Civil Aerospace cost base. It's a program of self-help, and that will enable us to create a stronger business with more sustainable cash generation and a permanently lower fixed cost base, regardless of whatever the pace of recovery happens to be. And as the next slide shows, it sets us up well to benefit from huge operating leverage as the market recovers. So let's look and see what that means for our future cash flows, on Slide 23. We can't control the pace and timing of recovery, which, in turn, is the main driver of recovery in both the aftermarket and the OE receipts part of our business. So those are the blocks above of the axis. But what we can control are the blocks below the axis, which I've just talked about on the previous slide. But here, you can see spread out in time. We can influence the rate of cash burn during the downturn. And also, consequently, the operational leverage that we enjoy as the flying hours improve. In 2020, large engine flying hours were 43% of 2019 levels, and we delivered around half as many of new large engines. Business jets and regional did show more resilience, but still, the fall in receipts was quite significant. And you can see our response in the reduction of the turquoise bars below the line, representing the operating cost and capital spend. And that begins in 2020 with the cash mitigation that I talked about. But it continues in 2021 and 2022 as the restructuring program makes those savings permanent and expands them even further. However, due to supplier lead times and working capital movements, in 2020, it simply wasn't possible to reduce our total costs at the same pace that we saw in the fall in receipts. And that's what drove the Civil Aerospace trading cash outflow of £4.6 billion. In 2021, this does begin to improve because that purchasing reduces with lower volumes and as we're able to turn off those taps, we still have a working capital headwind to contend with, and that is driven primarily by the OE concession payments that we talked about shortly before Christmas as a backlog of 787 aircraft are delivered by Boeing, and that triggers payments from us to airlines. The timing of this is completely outside of our control. And while we expect significant concession outflow in the first half of 2021, we may slip a little bit to the right. Nevertheless, you can see the cash flow as a whole begins to improve in 2021. Once the market recovers more fully, you can see Civil Aerospace returning to positive cash flow. And assuming flying hours reach approximately 80% of 2019 levels, on average, in 2022, we will see the Civil Aerospace business delivering cash flows that support our group ambition of at least £750 million of free cash flow. Looking longer term, the actions that we've taken to change our cost base and position for the recovery mean we're confident we'll be able to keep those costs low as volumes increase and that will deliver better cash margins in the future than we have achieved in the past. So that brings me back now to the group outlook for the near term, on Slide 24. We're expecting free cash outflow of around about £2 billion in 2021. The first half will see the worst of the outflows, mostly due to the shape of expected flying hour recovery and the timing of those concession payments. In the second half, there should be benefits as the vaccine and testing allows more routes to reopen and working capital pressure begins to ease on those concession payments. Both halves are expected to see cash outflow overall. But at some point during the second half of the year, we expect net cash outflow to become net cash inflow, marking the inflection point in our recovery. Now as we move into 2022, we expect those improvements to continue and drive sustainable positive cash inflow and that could total as much as £750 million in the year as a whole in 2022. And that's not adjusted for any disposals that may have completed by then but it does remain contingent on the recovery in flying hours to at least about 80% of 2019 levels. Now despite the uncertainties of the exact timing of that, we're confident that over a 12-month period, starting at some point in 2022, we're going to achieve that target. Looking further ahead, our ambition to get back to at least £750 million as early as 2022 includes up to £500 million of temporary headwinds from the Trent 1000 fixes and the closure of our overhedged positions. So our projected future cash flows will benefit as these diminish in the years going forward. So Slide 25, now that we've -- that's effectively covered how we are restoring our financial performance. I'm going to move on to how we're positioning ourselves for the recovery and creating a sustainable future. And that's 2 things

Operator: [Operator Instructions]. We have the first questions coming from the line of Andrew Humphrey from Morgan Stanley.

Andrew Humphrey: I've got a couple, if I may. One is on flying hours. I mean I think on -- over January and February, Rolls-Royce flying hours, as far as we can tell, were around 36% of 2019 levels. Assuming they stay at a similar level over the rest of the first half, are we effectively saying we need to be at 75% of 2019 levels in the second half to meet the cash guidance for this year? And my second question is sort of a bit longer-term around XWB. You've obviously secured the exclusive position on the 900 until 2030. I was curious about the reason for specifying that variant. I mean I assume that the 800 and the 1000 would not be sufficiently large-volume opportunities in themselves for a competitor to make significant inroads in there. I'd be interested in your view on that. And also, does the kind of specification of sort of 2030 as an end date for that exclusivity mean, effectively, that could be dual-source from 1st of January 2031?

Warren East: Right. Thanks very much, Andrew. Well, let me take both of those. I mean the engine flying hours, undoubtedly, we can see what's happened in the first couple of months. And there is a huge amount of uncertainty still in the timing of the recovery. And yes, our base case does expect a recovery to resume in the summer. Things like vaccine rollouts and the efficacy of vaccines are important to that. But also airport testing or health passports or whatever the solution is going to be will also require government to government interactions and lastly, public confidence, people have to actually get on the airplanes. So yes, there's a lot of uncertainty. And yes, the arithmetic that you suggest about overall percentage of engine flying hours is there. Of course, don't forget, engine flying hours, there isn't a literal connection of engine flying hours to our cash performance this year, but there's definitely a directional relationship. And our base case does depend on that recovery. So we'll just have to wait and see. And we're going to concentrate and continue to concentrate on the things that we can control and manage the things that we can't control, like timing and pace of recovery. On XWB 900, you'll recall, 12 months or so ago, there was a huge amount of speculation about our competitive position on A350 and GE having conversations with Airbus and so on. A huge amount of speculation and uncertainty in the community. And so we're delighted to put that speculation to bed for the remainder of this decade. And you're right, the 900 variant is the volume variant. It's a hugely successful airplane. And technically, yes, when a period of exclusivity finishes at the end of 2030, then it could be dual-sourced at the end of 2031. But as I pointed out in the presentation a moment ago, the 2030 date does coincide pretty much with the timing of likely UltraFan and next-generation aircraft and those sorts of things. It's a useful round date as well. To say exclusivity to the middle of March 2031 or something like that doesn't seem like a very -- seems spuriously accurate date. So we'll see. But for now, we're delighted with confirming the exclusive position across all the variants of the A350.

Operator: We have the next questions coming from the line of Celine Fornaro from UBS.

Celine Fornaro: If I may, I would have two questions, please. The first one is regarding your £750 million free cash guidance for 2022. So if we try and work it backwards a little bit in terms of the businesses, we know that roughly the non-Aerospace part of the business would generate approximately £700 million of cash and then you would have £600 million of headwinds coming from the tax, interest and the hedge book. So that would imply that Aerospace basically needs to generate roughly £600 million in 2022 with a scenario of 80% flying hours. I just -- this is way above the 2019 level, which was in the high 400s. Maybe you could just explain to us the path towards that and if this logic seems accurate based on the headwinds on aftermarket and the rebased volume offset somewhat by restructuring. And then my second question would be I've just seen this morning an appointment, a new appointment with a new effect on the Board by Mr. Paul Adams. So maybe you could share a few words on his background and what he would bring to the business given his operational focus. You are midway through a restructuring and a potential portfolio sale of some assets.

Stephen Daintith: Celine, it's Stephen here. So let me start with bridge to the £750 million free cash flow as early as 2022 that you referenced. And you're absolutely right, the key driver here will be the recovery and turnaround in Civil Aerospace. Let me just take you through -- if I just work, let's say, from the outflow of £4.2 billion that we saw in 2020 and take you through to 2022 and what are the key drivers of that material improvement in free cash flow over those 2 years. So first of all, the single-biggest driver is of course the improvement in the engine flying hours that we see, close to £1.2 billion of cash flow improvement. And that's essentially driven by engine flying hours rising from the 43% of 2019 levels that we saw in 2020, particularly in the final 9 months of 2020, improving to the guidance that we're giving today of our expectation of around 8% of 2019 levels in 2021 -- sorry, in '22. And every 1%, as a rough rule of thumb, equals £30 million. So there's a -- that is your first key item really in that bridge. We're then also expecting to see about £900 million of improvement in Civil Aerospace just in market impacts, and this will be around the regional engines, the V2500 and just generally, wide-body time and material improvement. That's going to be a big driver of that. We're also going to see higher spare-engine volumes in 2022 that we saw in 2020, which was a pretty subdued year for spare-engine demand, as you might expect. And finally, a key thing that we shouldn't forget about in Civil Aerospace is we're going to see around £300 million lower Trent 1000 costs. We're about £520 million this year. That will reduce to around £200 million or so in 2022, so that's another key driver. When we look at Power Systems and ITP, put those 2 businesses together, we're probably going to see around £200 million of improved cash flow out of those 2 businesses in 2022. Another key item that we're working through and, in fact, this is an item that we've made good progress on during 2020 is our group restructuring program. We're expecting a £500 million contribution from that compared to our 2020 numbers. Those are reductions in operating costs and capital expenditure. Just as a reminder on that, the cash mitigations of the £1 billion of savings that we delivered in 2020 were against our pre-COVID budget, whereas the £1.3 billion of restructuring savings that we first indicated on the 20th of May, when we announced our 9,000-headcount reduction, they're measured against our 2019 cost base. So in short, this difference means that despite the 2020 mitigations, there's still £500 million of benefit to come across '21 and '22 and not just the headline £300 million. Another key point here is to bear in mind that we actually see a reduction in the 2020 temporary headwinds as well that we saw, and these are 2 key areas, really. Number one is in the fixed cost under-recoveries, particularly in Civil Aerospace, to the drop, sharp drop in volumes that we saw in 2020 as COVID really kicked in and that we've talked about the OE volumes just now. And then we've also got a one-off FX impact in 2020 as well as our U.S. dollar costs exceeded our revenues. And in that scenario then, we translate rather the achieved rate at the prevailing spot rates at the time, closer to sort of £130 million-or-so rather than the £150 million-or-so in the hedge book. And given that our costs exceeded our revenues in 2020, that has a material around £400 million FX headwind to 2020 that won't be repeated in 2022 as our revenues and costs get closer aligned in U.S. dollars. Finally, we had a £200 million increase in pension, interest and tax, pension cost swings in 2020 due to a deferral of the 2020 cash costs into '21. So that's another item in that respect as well. So that gets you to the £750 million as early as 2022. And I would put some qualification around that, very much dependent on the 80% of engine flying hours that we've highlighted today and also very much dependent on the pace of our restructuring program and the delivery of the savings as well. I think we've made very good progress during 2020. There's still much to do, particularly as we get into the discussions around the potential site implications in Civil Aerospace. But we're pleased with the progress that we're making and pretty confident about delivering those full savings from our restructuring program. That's it really on the £750 million. Warren?

Warren East: Great. Thanks, Stephen. And on Paul Adams, well, we're very pleased to welcome Paul Adams to the Board. I'd point out that we also highlight that 3 of our directors are leaving the Board. They're timing out. And so this is part of the normal succession process. Now Paul was Head of Engineering at Pratt & Whitney for some years, and so he clearly has some very relevant industrial experience. And that compensates for some of the industrial experience that we are losing with the timing out of those 3 directors. But it's also very relevant industry experience. And I think his technical background is going to be particularly useful as we go through the next decade with next-generation engines to bring on and transition to new technologies.

Operator: We have the next questions coming from the line of Chloe Lemarie from Exane BNP Paribas.

Chloe Lemarie: I have two as well. The first one would actually be building on Celine's question on 2022 free cash flow. If we keep all things equal and add back we're missing 20% flight hours to go back to 2019 level, I would assume you could deliver about £1 billion from civil and even possibly £1.5 billion once the hedge book and Trent 1000 headwinds have gone. So could you say whether this is broadly your ambition for the division or would there be elements that would cap that performance going forward? And the second is on your R&D and technology road map. Would you see the need to return to past R&D peak by, let's say, the middle of the decade as you help fund that innovation to move towards the decarbonization goals? Or are these technologies actually less R&D-intensive than prior programs, having quite a lot of commonality with your existing portfolio?

Stephen Daintith: So thank you. I'll do the first question, Warren, and I guess, you'll do the second.

Warren East: Yes, that's fine.

Stephen Daintith: So yes, it's a good point actually, the £750 million as early as 2022, that actually includes Trent 1000 costs. We're guiding those costs in that year of between £100 million to £200 million in Trent 1000 costs. That's pretty much the final year of material Trent 1000 cash costs. And then we've also got within that number, the cash cost of closing out those FX forward contracts in respect to 2022 as well, and that's around £300 million. So you put those 2 numbers together, neither of which will be permanent, the Trent 1000 costs will stop earlier than the FX cash costs, and you'll see in the appendix the timing for those total cash costs. And just as a reminder, on a profit basis, we took all of the profit impact, about £1.7 billion, in underlying costs as part of our financing costs in 2020. So the P&L impact of that has already rippled through, but the cash profile rippled through across from 2020 through to 2027. So your interpretation is correct that one could see a route to free cash flows greater than £1 billion in the absence of those 2 headwinds. Warren?

Warren East: Yes. And the question on R&D. Well, I mean, clearly, we are talking about being -- having an organization that is a science-led innovation. And so we could spend almost anything on R&D. But our challenge is to make sure that we can do this in a profitable and effective way. And we've made -- if you push COVID to one side for a moment, we've made lots of investments over recent years to enhance the productivity and efficiency of our engineering efforts. And so yes, we remain absolutely confident that we can maintain R&D within the sort of envelope that we've now established, which is significantly less than it has been over the last several years. But don't forget, two factors driving that, the improvement in efficiency and productivity, but also the fact that we're coming to the end of the investment -- the big investment cycle in new engines in our Civil Aerospace business. And that's why we're able to make a massive change, like I showed on the slide a moment ago, in terms of how much we're spending on Civil Aerospace, tilting the investments that we are making into the other divisions and also into the newer technologies. So you'll see the absolute level of R&D remain roughly flat. You'll see the shape change significantly.

Operator: We have the next questions coming from the line of Chris Hallam from Goldman Sachs.

Chris Hallam: Yes, so three quick questions. First, on Slide 14. Are you able to put any time frame around the £2 billion of cumulative organic free cash flow that you've highlighted after 2022? And should we assume that, that's net of a 2.5x dividend cover ratio, i.e., that you're paying out 40% of free cash flow and dividends over that period? Second, back in February 2019, you withdrew from the NMA due to the tight schedules associated with the program. If it comes, it seems like the EIS date for that program has been pushed out to 2027 or so. And obviously, you've continued to make progress on UltraFan in the past 2 years. So is there a chance that you're interested in that program once again? And then finally, if the U.K. were to significantly reduce the number of F-35s it plans to operate, would that have a meaningful impact on your Defence business? Or should we think about that being driven more by the global fleet number than by the U.K. fleet number?

Stephen Daintith: So we're really talking in the midterm sort of 3, 4 years is the time frame that we're referencing there. I mean clearly, a lot of uncertainty ahead still, a lot of restructuring to do and a lot of engine flying hour recovery to happen. But that's a sort of rough guide on the timing. And I -- sorry, Chris, I missed the second part of the question there. I was writing down the first part of the question. So what was the second part of the question again? I missed that one.

Chris Hallam: Yes, sorry. So precrisis, you used to operate on a 2.5x dividend cover ratio, right? So you used to pay out 40% of your free cash flow in dividends. So as you try and get to net cash, are you assuming within that net cash position that you will have paid out around 40% of free cash flow in dividends?

Stephen Daintith: No. That is not part of the -- of that modeling right now. I mean it is something that we clearly will be considering. As we get into sort of 2023, I would imagine will be the earliest that start considering the dividend coming back. I mean we clearly want to be in a world whereby we've come out of COVID the other side. We're confident in our cash flow profile. We are very keen to get back to a -- that net-cash position that you just described. And we can see a route there, as I said, over the next sort of 3, 4 years or so. And at that point, I think, we'll be ready to have the debate about dividends. But right now, we're laser-focused on our disposals program, generating the at least £2 billion from that program and very focused on the restructuring program and getting this business back to the sort of economics that make sense for Rolls-Royce. That £750 million as early as '22, that's the first gating point and then taking it beyond there, particularly as the Trent 1000 FX headwinds disappear as well. But I think it's going to be around, at the earliest, '23, '24 debate around the dividend pick-up again.

Warren East: Okay. And so your second question, Chris, was around UltraFan and NMA, I suppose. And yes, you're right. We were very explicit about the reason why we withdrew from that proposed program a couple of years ago and that was around the timing of our UltraFan program. Our UltraFan development has gone well since then. And we're sort of gearing up for a demonstration early next year. So then it will depend -- whether we go ahead with it at that stage or whether we pause at that stage, it will depend on the timing of new aircraft programs. And the product is -- or the product will be scalable. It will go across single-aisle and dual-aisle applications. It will be applicable for new aircraft, compatible with 100% SAF and so on. So yes, it's quite applicable. But we'll have to see if programs actually materialize and when they do. On the F-35s and the U.K. government's cancellation, then actually, obviously we're more geared to the whole sort of global F-35 program than just the U.K. program. But I would also note that the U.K. is talking about channeling that investment into the Tempest program, where we are obviously playing a crucial role.

Operator: We have the next questions coming from the line of Andrew Gollan from Berenberg.

Andrew Gollan: So two questions for me, please. One on new engine volumes and one on shop visits. So on the new engine volumes, you've lowered the outlook slightly to, I think, £200 million to £250 million, which is understandable, I suppose. So firstly, can you give us an update on the engine unit losses in 2020? And with that kind of lower-for-longer-volume outlook, what's the trajectory you're expecting now for reducing that number going forward? And I guess I'm referring here to the pre-COVID target of £0.4 billion per engine? And then second question on shop visits. Can you break out the volumes in 2020 as you have done before? So in terms of major refits and check and repair. And what is assumed within the cash guidance over the next couple of years, in particular, please?

Stephen Daintith: Right. Yes, let me start on the OE volumes. I mean of course, on our OE volumes, we are completely dependent on the airframe build rates. And I think in 2020, we demonstrated a certain amount of flexibility being able to respond to that and manage our supply chain accordingly. So we will just respond to those build rates. As far as the losses are concerned, in 2020, whilst we can respond to build-rate changes, in 2020, the change was rapid. And so actually, OE losses as we came into the year at full throttle, we had no chance whatsoever of being able to respond and scale down our operation quite as fast as the volume disappeared. So lots of under-recovery in 2020. And so in a way, the 2020 number was pretty meaningless as far as our forward-looking ambitions are concerned. Now to those forward-looking ambitions, however, we're -- that is precisely why we are resizing our business with this restructuring, that is to deal with the anticipated OE volumes and also the anticipated volumes of spare parts for the aftermarket. And so I think we'll be back with more news about OE loss ambitions. But hopefully, we're resizing our operation accordingly to meet those lower volumes.

Warren East: Okay. So shop visit volumes. We actually have quite a bit of this detail already on Page 12 in the first half of the release, but I'll go through it in any event. In 2020, we had 278 -- sorry, 272 large engine major shop visits, as you described in those -- major refurbs. In 2021, that number is going to be closer to 240. So a slightly lower level. But that's going to start to -- it rises then quite sharply as we're talking around 2022 to around 400 in 2022. So that's the broad trajectory of major shop visits over the course of the next couple of years compared to our 2020 levels.

Andrew Gollan: That's helpful. And all the best, Stephen, in your next challenge.

Stephen Daintith: Thank you very much.

Operator: We have the next questions from the line of Ben Heelan from Bank of America.

Benjamin Heelan: One on retirement because we haven't really touched on that in great detail. You do still have a relatively large exposure to four-engined aircraft and retirements should be picking up as we go through 2021. So how do you think about the impact of retirements of 380s, 340, 747s on that flight hour recovery?

Stephen Daintith: Yes. Well, we're not guiding specifically on retirement today. But when we look at our engine flying hour forecasts, which are -- what the guidance is or what's really the driver for aftermarket revenue, then we're effectively taking into account that retirement risk. I mean we know that airlines are preferring the newer aircraft. We showed that in the presentation. And we do have exposure to some of these older aircraft. And undoubtedly, airlines are going to retire the less efficient aircraft more quickly and in preference to the others. So yes, we're taking that into account. And in fact, in the data appendices to the presentation, then I -- we've got the data about those older aircraft and what happened in 2020, and that's probably an indicator of what airlines are doing.

Operator: We have the next questions coming from the line of Robert Stallard from Vertical Research.

Robert Stallard: I have a similar question to Ben, actually. Looking in the back in the appendices, roughly 1/4 of your civil revenues in 2020 came from time and material and other, and that actually held in pretty well compared to long-term service agreements. So I was wondering if you could explain what was going on there. And also looking forward into '21 and beyond, how do you expect T&M to track from here?

Stephen Daintith: Yes. Well, basically, we expect T&M to track with activity. The long-term service agreement actual numbers were hit by the catch-ups. And so if you want to look at sort of activity, then look at shop visits and how those are developing. And time and materials is more of a reflection of activity, whereas long-term service agreements are wrapped up in accounting as well as what's actually going on in the field. So that's the difference. And we would expect time and materials for those engines where we have time and material contracts, that will just reflect flying activity as we go forward. And therefore, the recovery.

Robert Stallard: Can I just follow-up on that? Because down 9% year-on-year would seem a very good performance given the prevailing activity we saw in 2020. So I was wondering if there was any offsets in that number.

Stephen Daintith: Yes. Well, I think 2020, we have to regard as an unusual year, and that's the way I'd sort of look at it. I mean don't forget, we came into the year with a bit of a backlog of airplanes needing shop visits. We did take the opportunity of 2020 to burn down those queues and that also meant burning down some of the time and materials demand as well.

Operator: Your next questions come from the line of Jeremy Bragg from Redburn.

Jeremy Bragg: I wanted to ask, please, again, on the £750 million guide for 2022. So you're achieving it despite lower engine flight hours. So I wondered if you could elaborate, please, on what the mitigating factors were and whether the cost cutting is just happening a bit sooner or whether there's a potential for it to actually wind up being bigger than the £1.3 billion. That was the first question, please. And then the second question was on the IAE royalties, which I wonder if you could quantify them for 2020 and give a kind of view of what's baked into the 2022 guidance because that's, again, rather like the FX, something which doesn't last forever.

Stephen Daintith: Okay. So thank you for that. I'll start off with the £750 million. Yes, you're quite right, back in October with the rights issue, we highlighted a £750 million number as early as 2022, but based on engine flying hours being at 90% of 2019 levels. And we're now reconfirming that £750 million, but obviously with a lower 80% of 2019 levels. I think the key driver of this is we actually made really good progress in 2020 in our restructuring program. We got further than we thought we would and which means that we're delivering those savings earlier than we thought. And in 2022, the £1.3 billion of savings that we've quoted is the exit run rate at the end 2022, so clearly, we're getting that earlier. We're going to get it earlier in 2022 as well, and that's one of the key drivers. I think another aspect here is that there have been some benefits from COVID. We now have a 13-week rolling cash flow forecast by business that's given us more granularity than we've ever had, I think, into the operations of our individual businesses. We've been working hard on our budget for '21 and '22 since October with the rights issue, and that's identified, I think, some further opportunities for improvement, particularly around our capital allocation and operating costs to help us reconfirm that £750 million. And we've got a pretty robust plan, I think, for the next couple of years now. There are some timing items that have impacted 2021, that £2 billion cash outflow in 2021 that may benefit 2022. So there's an item there just to bear in mind as well. I think as it stands, though, we are pretty comfortable with the £750 million as early as '22, but very much dependent on that 80% of engine flying hour level in 2022 compared to 2019 levels. And again, that in itself is very much dependent on the recovery in the second half of the year, as Warren talked about once the vaccination programs globally kick in. I mean it's become apparent, talking to other countries and our customers in the aerospace sector generally, that the rollout of the vaccination program will be a really key gating item. And I think most countries looking for a majority of their population to have been vaccinated before global travel restrictions start to get lifted in a meaningful way. So that is probably the one key indicator for us to watch out for.

Warren East: I'll pick up the second half of the question. Just as I start on that, I'd also point out that the U.K. government is hosting the G7 this year. And this getting flying going again is a sort of multi-government thing that has to happen. And so our government relations team are very much spending time and effort lobbying the U.K. government to play a leading role in getting this risk-based approach to opening up flying again. Now IAE royalties. IAE royalties simply pretty good reflection of the flying hours for that V2500 engine. And so in 2020, very roughly, 50% down. We expect to be recovered quite a bit in 2022. Don't forget that this is effectively a single-aisle. It's a short-haul aircraft. Short-haul recovers before long-haul. And so we would expect that to come back a bit more substantially than most of our activity, which is wide-body long-haul, by 2022. But also, don't forget that this royalty stream is going to disappear in 2020 and -- or in 2027, anyway. So it's one to note, but it's not really the major driving factor of our business.

Jeremy Bragg: A follow-on, please. What were the timing items that might benefit 2022 -- 2021 -- sorry, what were the timing items that might benefit 2022, please? You mentioned that, but I wasn't really...

Stephen Daintith: The item here, and we talked about this before, is credit notes that we've issued in respect to the Trent 1000 customer disruption. I think in the main, that's one of the items that we -- no surprise, our airlines' using their credit notes earlier. And we're working actually pretty well with our airlines to help them through their cash pressures to the extent that it's appropriate for us to do so and not to damage ourselves. But I think it's the early use of credit notes is the one thing that I would point to that are in the '21 numbers and therefore benefit 2022.

Jeremy Bragg: Got you. Okay. And good luck, Stephen.

Stephen Daintith: Thanks very much.

Operator: We have the next questions coming from the line of Sean Stewart from JPMorgan.

Sean Stewart: I have four, please. Firstly, and similar to Ben's question, your base case is for engine flying hours to be 80% of 2019 levels in 2022. But what is your assumption on the size of the fleet in 2022 versus 2019? And then secondly, your guidance on free cash flow to greater than £750 million as early as 2022, which essentially has a lot of flexibility as far as guidance goes. Are you able to provide us with the minimum guide on free cash flow actually in 2022 on the current perimeter? And thirdly, Warren, you provided some color on some of your near-term margin expectations for your Power Systems business. Given that you retained Civil Aero as somewhat tied to shop visit activity and engine deliveries, 2 things that you have guided on and which are perhaps not as volatile as the outlook for engine flying hours in the near term, please, can you provide us with like your margin expectations in the Civil Aero business in 2021 and 2022? And then finally, you subjected some assets into ITP to make it perhaps more attractive to a potential buyer. Are you able to please quantify what the sales and EBITA -- what sales and EBITA have been injected into that business, please?

Stephen Daintith: Yes. Right. There's quite a lot there, and I have to say I didn't hear all of it completely accurately. But let's have a go at some of them. So size of the fleet in 2022. Look, we're guiding -- or we're not guiding. We're making assumptions about the engine flying hours that we expect in 2022. And that's the -- that's a reflection of activity. It's a reflection of airline schedules and their current plans, combined with top-down forecast. Now in those current plans, we're not taking particular -- it's about airline schedules and their expectations. Exactly how many airplanes they're going to have servicing those routes is not something that is of particular relevance to us. And so yes, we're taking retirements into account, things like A340s retiring and four-engine aircraft generally retiring more than the ones that are current [Technical Difficulty].

Operator: We have the last questions coming from the line of Harry Breach.

Harry Breach: Yes. Can you hear me, Warren and Stephen? Can you hear me?

Operator: Please bear with us. One moment, please. [Technical Difficulty].

Stephen Daintith: So we're not giving -- sorry, I've just been told here the line's -- shall I carry on? Okay. I'll carry on with my answer. We're not giving minimum -- 2022 free cash flow guidance. But to help you, what I would say, all things being equal, engine flying hours is the key thing to watch out for. So 1% equals around £30 million and £750 million, we've said 80%. So variation around that 80% number of 2019 levels, 1% equal to £30 million. That's probably as best as I can give you in terms of a minimum number for 2022. On your other questions, we're not guiding on civil profits. We haven't done previously and nor do we intend to. It's a level of detail that we're not going to go into. I think even now it is less likely, more than ever, given the general uncertainty generally as we're still in the thick of COVID and we have all the recovery ahead of us to go through and the restructuring program to go through as well. So I think that's probably going to be something to say, but for this time next year.

Isabel Green: I think there may be a small interruption on the line there. If anybody did miss part of Stephen's answer and wants to come back to Investor Relations later, we can run through that again. Apologies, but I think some of you may have lost sound for a short period. Back to you, operator. Sorry, is there any more questions online? If not, I've got a -- just 1 on the webcast. I'm going to -- actually, sorry, 2 on the webcast, I'm going to turn to. Firstly, Nick Cunningham here from Agency Partners wanting to know more about the longer-term pattern for the major overhauls and wanting to know the impact that has as those visits start to ramp up in the later years. So if you've got any further commentary on the cash growth skyline of the overhaul scenarios, that would be welcomed by Nick.

Stephen Daintith: Yes. I mean, Nick, the shop visit volumes will start to increase. I mean you all have seen that from the big orders that came through over the last 3, 4, 5 years, those first shop visits start to flow through, and that is built into our plans. They will grow but so, at the same time, do engine flying hours. At the same time, we see the nonappearance of the FX costs that I talked about earlier, and we also will have seen the back of the Trent 1000 cost by then as well. So despite that growing shop visit volume and therefore, the cost headwind that goes with it, there are some very significant tailwinds as well ahead for us. So that's how we compensate that.

Isabel Green: Just asking one last question, and apologies for anybody who didn't get their question answered. Obviously, we will come back to you individually if you weren't able to get a response online. There's a question here about SMRs for Warren. Just saying are you confident in sort of a 2030 target for SMRs given the pressures on R&D spend and how we're making those priorities. So if you have any comments you'd like to make on the SMR outlook, that'd be appreciated.

Warren East: Yes. And so the answer is we're confident in the program at the moment. I mean this is very early stages at the moment. Just had the government go ahead and we'll be fleshing out the detail on that, I think, over the next 18 months to 2 years. But suffice to say, we think it's a very exciting program. Rolls-Royce has absolutely unique expertise in this area. And we see it as an essential piece of net zero for the U.K. but also excitingly, as I pointed out in the presentation, for other applications like SAF and hydrogen. So we'll flesh that out over the next couple of years.

Isabel Green: Okay. Thank you. That's -- I'm afraid that's all we've got time for on the webcast questions. We have run out of time. Just to say, for anyone who missed that period of answers, we will make sure there is content in there in this transcript, which will be out later today or if not, maybe tomorrow on our website. So sorry if anyone missed that, the answer will be published. Back to you, Warren.

Warren East: Great. Well, thank you very much, everybody. The messages that we need you to take away are that the worst is behind us as far as COVID is concerned. I'm very pleased with the progress we're making on the fundamental restructuring, particularly of our civil business to reset the economics of our civil business and give us great operational leverage as the recovery happens. And that's going to mean that we can tilt the balance of our capital allocation going forward so we're well positioned for this future recovery and a net-zero world in the future. Thanks very much.

Operator: Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect your lines. Thank you.