Business Finance: Brexit and Rolls-Royce

The Impact of Brexit on Rolls-Royce

The decision by the people of the United Kingdom to leave the European Union-Brexit-in June of 2016 raised many questions over the future of many of the U.K.’s multinational firms. One firm in the limelight was Rolls-Royce, one of the premier aerospace engine manufacturers in the world.

• Rolls was one of Britain's major exporters, credited with roughly 2% of the country's annual exports.

• Following Brexit, and the sharp decline in the British pound sterling, analysts were attempting to gauge how the EU exit would alter the company's business, and how the company's leadership was likely to react.

• Rolls-Royce Holdings PLC is a U.K.-based multinational group that designs, manufactures, and distributes power systems to the aviation (civil and defense), marine, nuclear, and other industries.

• It is listed on the London Stock Exchange (LSE: RR) and is a member of the FTSE 100 index. It is the second largest manufacturer of aircraft engines in the world.

• But Rolls had a serious, long-term, structural currency problem. Although based in the U.K., with most of its manufacturing operations in British pounds, its global sales were dominated by the U.S. dollar.

• This reflected the location and identities of its major customers like Boeing and Airbus. As illustrated in Exhibit A, this structural currency mismatch meant the company had a significant operating exposure problem, earning primarily U.S. dollars when paying out British pounds and euros.

• Since many of Rolls' sales programs were lengthy, often between three and six years in length, this long-dollar position was not only large, it was relatively predictable over time.

The result was a multinational company that was long IJ.S. dollars and short Bñtish pounds. If the U.S. dollar then appreciated versus the British pound, Rolls-Royce benefits. If, however, the dollar was to fall in value versus the pound, sales, earnings, and cash flows would fall in value as reported in British pounds.

• In the summer of 2014, the pound began to fall against the dollar, a favorable movement for Rolls that the company could not fully enjoy given its lock-in hedge program.

•  Publicly traded companies like Rolls must continually worry about short-term market movements while keeping long-term competitiveness in their sights.

• Exhibit C attempts to provide some longer-term perspective to the challenge Rolls faces.

•  The exchange rates that matter the most, the dollar and euro against the pound, show varying periods of relative strength and weakness over the past 25 years.

•  The pound has enjoyed a long period of relative weakness against the dollar and euro, but the recent Brexit vote seems to have pushed it down to a level not seen in the past quarter century against the dollar.

• Like other U.K. companies, Rolls was trying to decide whether or not to continue to invest in its operations and facilities in the U.K., or possibly redirect that investment to Continental Europe.

• No longer an EU member, U.K.-based companies now faced the possibility of being treated as outsiders to the Continental European markets, raising threats of trade restrictions, regulatory distinctions, and documentation requirements and delays.

• Rolls-Royce said it has held “high-level” talks with ministers about the areas that it is keen to resolve after the Brexit vote, while the UK boss of Airbus said he did not want to deal with thousands of pages of documents and tariffs when dealing with his colleagues in mainland Europe.

1. Why do you think Rolls has continued to bear this structural currency mismatch for so long? Why hasn't it done what many automobile companies have done, and move some of their manufacturing and assembly to the country in which the customer resides?

2. Why are Rolls-Royce’s foreign currency hedges performing so poorly? Shouldn't the hedges be protecting its sales and earnings against exchange rate movements?

3.  If you were a member of the leadership team at Rolls-Royce, what would you recommend the company do to manage the risks arising from Brexit?