Annual Report and Accounts

10 March 2009 Annual Report 2008 Publication of the Annual report Rolls-Royce Group plc announces that its Annual report for the year ended 31 December 2008, the Annual review and summary financial statement and the Notice of Annual General Meeting are now available on the Company's website: www.rolls-royce.com Printed copies of these documents will be posted to shareholders on or around 24 March 2009 and they will shortly be available for inspection at the UK Listing Authority's document viewing facility at 25 The North Colonnade, Canary Wharf, London E14 5HS. In accordance with paragraph 6.3.5 of the Disclosure and Transparency Rules we set out below a management report extracted from the Annual report in unedited full text. Accordingly, page references in the text below refer to page numbers in the Annual report. A condensed set of financial statements was included in our final results announcement issued on February 12, 2009. The Annual report contains a responsibility statement in compliance with DTR 4.1.12 signed on behalf of the Board by Tim Rayner, General Counsel and Company Secretary. This states that on February 11, 2009, the date of approval of the Annual report, each of the persons who was a director confirmed that to the best of his or her knowledge: i. each of the Group and parent company financial statements, prepared in accordance with IFRS and UK Accounting Standards respectively, gave a true and fair view of the assets, liabilities, financial position and profit or loss of the issuer and the undertakings included in the consolidation taken as a whole; and ii. the Directors' report on pages 1 to 84 of the Annual report included a fair review of the development and performance of the business and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they faced. The Annual General Meeting of the Company will take place at 11.00am on Thursday April 30, 2009 at The Queen Elizabeth II Conference Centre, Broad Sanctuary, Westminster, London SW1P 3EE. Cautionary statement regarding forward-looking statements This announcement contains certain forward-looking statements. These forward-looking statements can be identified by the fact that they do not relate only to historical or current facts. In particular, all statements that express forecasts, expectations and projections with respect to future matters, including trends in results of operations, margins, growth rates, overall market trends, the impact of interest or exchange rates, the availability of financing to the Company, anticipated cost savings or synergies and the completion of the Company's strategic transactions, are forward-looking statements. By their nature, these statements and forecasts involve risk and uncertainty because they relate to events and depend on circumstances that may or may not occur in the future. There are a number of factors that could cause actual results or developments to differ materially from those expressed or implied by these forward-looking statements and forecasts. The forward-looking statements reflect the knowledge and information available at February 11, 2009, the date of signing of the Annual report, and will not be updated during the year. Nothing in this announcement should be construed as a profit forecast. Enquiries: Investor relations: Mark Alflatt Director of Financial Communications Rolls-Royce plc Tel: +44 (0)20 7227 9246 mark.alflatt@rolls-royce.com Business review Introduction Rolls-Royce is a global business providing and supporting integrated power systems for use on land, at sea and in the air. The Group has a balanced business portfolio with leading market positions. 2008 2007 Change 2006 2005 2004 ______________________________________________ _____ ____ _____ ____ ____ ____ Order book - firm and announced (Â£bn) 55.5 45.9 21 % 26.1 24.4 21.3 ______________________________________________ _____ ____ _____ ____ ____ ____ Underlying revenue (Â£m)* 9,147 7,817 17 % 7,353 6,458 5,947 ______________________________________________ _____ ____ _____ ____ ____ ____ Profit before financing (Â£m) 862 512 68 % 693 877 417 ______________________________________________ _____ ____ _____ ____ ____ ____ Underlying profit before tax (Â£m)** 880 800 10 % 705 593 364 ______________________________________________ _____ ____ _____ ____ ____ ____ Underlying EBITDA (Â£m) 1,244 1,065 17 % 979 933 717 ______________________________________________ _____ ____ _____ ____ ____ ____ Earnings per ordinary share (p) (73.63 ) 33.67 (319 %) 57.32 20.11 15.56 ______________________________________________ _____ ____ _____ ____ ____ ____ Underlying earnings per ordinary share (p)** 36.70 34.06 8 % 29.81 24.48 15.62 ______________________________________________ _____ _____ _____ _____ _____ _____ *Underlying revenues reflect actual US$ exchange rates on settled derivative contracts. **Reconciliation of underlying results is provided in note 2 on page 99 and note 5 on page 103 of the consolidated financial statements. Civil aerospace We are one of the world's largest civil aero-engine providers, with more than 12,000 Rolls-Royce jet engines in service. We power over 30 civil aircraft types, from small executive jets through to large passenger aircraft. Defence aerospace Rolls-Royce is the world's second largest defence aero-engine manufacturer, providing around 25 per cent of the world's military engines. Our portfolio covers all major sectors, including transport, helicopters, combat, trainers and tactical aircraft. Marine We are a global leader in marine propulsion for cruise, fast vessel, naval and offshore markets and a world leader in ship design for the offshore sector. We support 2,000 commercial marine customers and 70 navies use our propulsion systems and marine equipment. Energy Rolls-Royce is a world leader in power for the oil and gas industry and our gas turbines have a growing presence in the electrical power generation market. Our skills and technology will also address the growing global market for nuclear power. Services The Group seeks to be the customer's first choice for services by developing long-term relationships. Our comprehensive support contracts enable us to add value for our customers by using our technology, skills and data management expertise. Chairman's statement Simon Robertson I am very pleased to report that in difficult market conditions, Rolls-Royce has again performed well in 2008. We delivered a strong underlying profit and cash performance and our order book increased from Â£45.9 billion in 2007 to Â£ 55.5 billion in 2008. We are proposing a final payment to shareholders of 8.58p per share making 14.30p for the full year, an increase of ten per cent, reflecting the Board's continuing confidence in the Group's business. The adverse economic outlook inevitably creates huge challenges for all businesses and it is clear that Rolls-Royce will also be impacted. It is difficult to determine the precise scale of the impact on the Group until the severity of the current downturn is clearer. However, Rolls-Royce does enter this testing period with a number of significant advantages. We have pursued a consistent strategy, which has created a business that is well diversified in terms of its products, customers and geography. We also have a strong balance sheet with no net debt. Early action was taken to reduce operating costs and to put our pension schemes on a sustainable footing. We are therefore better prepared to deal with the uncertainties which undoubtedly lie ahead. The Board is committed to improving the environmental performance of our products through continuous innovation and the development of new technologies. For example, since the first commercial jet engines were produced our engineering expertise has helped reduce aircraft fuel burn by 70 per cent and noise by 75 per cent. We are also committed to reducing the carbon footprint of our operations. We have invested in new facilities and implemented energy efficiency measures that have delivered a reduction in greenhouse gas emissions of some 30 per cent over the last decade. We are actively developing opportunities in civil nuclear power and other low carbon technologies. The Board is determined to achieve and maintain best practice in all areas of corporate responsibility, including all aspects of health and safety. Unfortunately over the past two years we have had to announce some redundancies. The Board does not make such decisions lightly, as we take our responsibilities to our people very seriously. However, in order to reduce our operating costs in response to the global economic upheavals, the Board felt these were decisions it had to take. We attach particular importance to our businesses being run in a way which reflects the highest ethical standards. That is why we decided last year to establish a new Board committee, the Ethics Committee, under the chairmanship of Ian Strachan, to bring a better focus to this issue across the Group. There have been a number of changes to the Board during the year. We have welcomed John McAdam and John Neill as new non-executive directors, both of whom will bring valuable experience to the Board. Helen Alexander has been appointed as Chairman of the Remuneration Committee. Carl Symon has retired from the Board during the year after nine years' service and I would like to thank him for his valuable contribution to the Group. Sadly, Boris Federov, a valued member of our International Advisory Board, died suddenly during the year. I would like to congratulate John Rose who was recently made a Commandeur de la LÃ©gion d'honneur. I would also like to thank the management and all our employees for their dedication, hard work and commitment to the success of the Group over what has been a very demanding year. I am also indebted to my fellow directors for the support they have given to me personally and to the Group over this period. 2009 will clearly be a very difficult year for the world economy but I strongly believe that our business is particularly well placed to respond to these challenges and to take advantage of the opportunities that will undoubtedly arise. Simon Robertson Chairman February 11, 2009 Chief Executive's review Sir John Rose Rolls-Royce performed strongly in 2008 in the face of increasingly challenging conditions. Our results demonstrate the value of our consistent strategy. The strength of our technology, the breadth of our product and service portfolio, our knowledge of the customer and the capabilities of our people continue to increase our resilience and enable us to develop the business for the longer term. Our financial results reflect the strength of our business model. In 2008, Group sales increased to Â£9,082 million (2007 Â£7,435 million), with underlying sales growth of 17 per cent. The published loss before tax was Â£1,892 million (2007 profit Â£733 million). This loss was caused primarily by the effects of the marking to market of various financial instruments, as is explained further in the Finance Director's review on page 55, and the reported earnings do not reflect the underlying trading performance of the Group in 2008. Underlying profit before tax rose by ten per cent to Â£880 million (2007 Â£800 million). We ended the year with a net cash balance of Â£1,458 million (2007 Â£888 million) and a record order book of Â£55.5 billion (2007 Â£45.9 billion). As I write, the global economic crisis continues to intensify and it is impossible to be precise about its ultimate severity and duration. What is certain is that all companies will be affected to varying degrees and it is clear that Rolls-Royce, its customers and suppliers will not be immune from this global crisis. However, as a strong power systems company, Rolls-Royce has a number of characteristics which give me confidence that we will be able to deal effectively with the very considerable challenges and uncertainties that lie ahead. A very different company It is worth recalling at the outset that the current crisis is not the first to which Rolls-Royce has had to respond. In recent years our markets have been impacted by the events of September 11, 2001, the Gulf War in 2002 and the SARS epidemic in 2003. As a business, we have also had to deal with a wide range of negative developments such as a weakening US dollar, high oil and commodity prices and delays in major new airframe programmes. All these challenges have been effectively managed by the Group. The drivers of the current global economic crisis clearly differ significantly from previous downturns. However, Rolls-Royce itself is also a very different company. Our turnover in 2001 was around Â£6 billion, with only 38 per cent of our revenues derived from services. We had a geared balanced sheet with average net debt of around Â£1 billion and a large and volatile pensions deficit. Our order book of Â£16.7 billion was concentrated on traditional Western markets such as the UK and the US. As a result, in the downturn that started in 2000 but was exacerbated by the tragedy of 9/11, the Group was less resilient than today. Rolls-Royce is now well diversified by product, customer and geography. Our revenues have increased to over Â£9 billion with over 50 per cent now derived from services. Our order book has increased more than threefold to over Â£55 billion and is broadly spread across all the world's principal markets. Most significantly of all, we have a strong balance sheet with no net debt. Our long-term strategy of hedging currency risk has served us well, allowing a manageable and predictable deterioration in the sterling/US dollar achieved rate over the past five years. Our large installed base of over 54,000 engines supports a growing services business. The scale of this services activity, together with the size of the order book and the longevity of our programmes, gives us much clearer visibility of future revenues. All these characteristics increase the Group's resilience and despite the uncertain outlook, give us confidence for the future. In this more challenging environment, operational performance, cost reduction and matching capacity to load will be particularly important. In January 2008, we took early action to reduce costs by taking the difficult decision to reduce staffing in support functions by 2,300 people. This programme has been completed at no net cost to the Group and in 2009 will reduce our costs by Â£100 million. A further proposed reduction of 1,500-2,000 jobs in 2009 is expected to be cost neutral in the year, while delivering similar savings in 2010. These programmes demonstrate our commitment to achieving and sustaining world-class levels of operational efficiency and improving our competitiveness. Developing the business It is clearly impossible to provide a forecast of the precise impact that the global crisis will have on Rolls-Royce. However, it is clear that the Group's power systems portfolio - whether for use on land, at sea or in the air - provides products and services for which there will be a strong, global demand for the foreseeable future. Importantly, the sectors in which the Group operates are characterised by high barriers to entry because of the advanced technologies required and routes to market which have to be established and maintained. Rolls-Royce will be able to exploit these advantages over many years as the global economy recovers and resumes growth. A long-term business The longevity of our programmes, the scale of our order book and the increasing importance of our services activity suggest that over the next ten years the Group can double in size through organic growth alone. In civil aerospace, for example, based on our understanding of the order book and the long-term programmes in which we are involved, we see a market potential for around 8,000 wide-bodied aircraft over the next 20 years, a very significant opportunity for our Trent engine family. Investing for growth Rolls-Royce has a strong track record of developing businesses by investing in organic growth, partnerships and acquisitions. Our civil aerospace business is a case in point. Our acquisition of the Allison Engine Company in 1995 helped Rolls-Royce build up a strong position in the corporate and regional jet market through the highly successful AE 3007 programme. Our joint venture with BMW in 1990 enabled us to establish a new centre of excellence in Germany for two shaft engines, an important strategic development which culminated in the Group buying out BMW's share of the joint venture in 1999. Collaboration also played a key role in the development of the Trent programme, with Rolls-Royce agreeing an important series of risk and revenue sharing partnerships with a wide range of global companies. A consistent approach We are taking the same approach to develop our marine business which was transformed by the acquisition of Vickers in 1999. We gained access to new capabilities including design and integration systems, propulsion and control equipment, a global sales and services network and routes to market for the offshore and merchant sectors. This combination of a strong ship design capability and the provision of high technology equipment and systems has enabled marine to improve its market access and broaden its product offering. Defence aerospace has similarly been transformed from a narrowly focused business which was overly dependent on the UK to one which provides engines and service support on a global basis and across a wide range of sectors including fast jets, transport aircraft, unmanned vehicles, trainers and helicopters. We have more than 160 customers in 103 countries, with the USA now accounting for around 45 per cent of defence aerospace revenues. Exploring new opportunities as a power systems company Looking ahead, the Group can take full advantage of its strong systems integration capability based on its knowledge of technology, its close understanding of customers' needs and its ability as a power systems company to apply these integration skills in support of the customer. This will enable the Group to exploit its technological strengths in adjacent markets and to develop its existing businesses through partnerships and acquisitions. A good example of this is civil nuclear. In 2008, we established a new business unit to address the rapidly expanding global market for nuclear power generation which we estimate could be worth around Â£50 billion per year within 15 years. The civil nuclear opportunity plays to our strengths. It requires technological expertise, systems integration capabilities and a global supply chain, all of which we have developed during the 50 years we have designed, manufactured and supported nuclear reactors for the Royal Navy's submarine fleet. We will also use this approach to take advantage of other opportunities to address distributed power and alternative energy. World-class people In responding to the short-term challenges we are currently facing and in developing the business for the longer term, our people are our strongest asset. Rolls-Royce is a power systems company, powered by the knowledge, experience and imagination of all our employees across the world. Our advantages are dependent on the contributions they make and in this increasingly challenging period I am particularly indebted to all of our people for everything they do in support of the business. Future prospects The Group expects that in 2009 its global markets will be affected by reducing demand and the impact of financing constraints. We will continue to manage the consequences of airframe programme slippages. Cash generation will be affected by the reduction in new orders and associated deposit intake and the impact on inventory of any delays or cancellations. There are also likely to be requests for customer and supplier financial support which will be considered by the Group on a case by case basis. In the current environment it is expected that in 2009 despite a cash outflow, the average net cash balance of the Group will increase. The Group's current view is that underlying revenues will continue to grow and underlying profits for the year will be broadly similar to those achieved in 2008. Sir John Rose Chief Executive February 11, 2009 Our strategy As a power systems company, Rolls-Royce focuses on supplying its customers with integrated systems to meet their power and propulsion needs. Our consistent strategy has five elements: Address four global markets We are a leading integrated power systems company operating in the civil and defence aerospace, marine and energy markets. Invest in technology, infrastructure and capability Over the past five years, we have invested Â£3.7 billion in research and development. We invest approximately Â£30 million annually in training and over Â£300 million a year on capital projects. Develop a competitive portfolio of products and services We have more than 50 current product programmes and we are involved in many of the future projects in the markets we serve. These key projects will define the power systems market for many years. Grow market share and installed product base Across the Group, the installed base of engines in service is expected to generate attractive returns over many decades. Add value for our customers through the provision of product-related services We seek to add value for our customers with aftermarket services that will enhance the performance and reliability of our products. The core characteristics which define our business and underpin the delivery of this strategy are: Closeness to our customers We develop close relationships with our customers over many years. This allows us to offer solutions, often in partnership with our customers, to meet their specific requirements. Domain knowledge Underpinning our sales of equipment and related services is a deep knowledge of the overall environment in which our equipment is used. This allows us to provide the optimum level of service and focus our activities to meet our customers' needs and grow our business. Integrated systems We supply our customers with products, related services and whole systems. Our ability to integrate and optimise systems enables us to create value for customers in all our main markets. Technological superiority Our investments in technology and capability provide Rolls-Royce and our customers with competitive advantage. Operational excellence We aim to operate at the highest standards, to ensure that we continue to meet our customers' requirements in the quality, performance, durability and delivery of our products, systems and services. Organisational capability Because we are a global company we have the ability to recruit and retain capable people in many locations. Our investment in training and the varied career opportunities are key to our success in retaining high-quality people. Brand We have an exceptionally strong brand which is recognised globally and embodies qualities that create a common focus for all our people, wherever they are located. Our business Market outlook The Group operates in four long-term global markets - civil and defence aerospace, marine and energy. These markets create a total opportunity worth some two trillion US dollars over the next 20 years and: - have very high barriers to entry; - offer the opportunity for organic growth; - feature extraordinarily long programme lives, usually measured in decades; - can only be addressed through significant investments in technology, infrastructure and capability; and - create a significant opportunity for extended customer relationships, with revenues from aftermarket services similar in size to original equipment revenues. The size of these markets is generally related to world Gross Domestic Product (GDP) growth, or in the case of the defence markets, global security and the scale of defence budgets. Civil aerospace The Group publishes a 20 year global market outlook, which covers passenger and cargo jets, corporate and regional aircraft. We predict that over the next 20 years 131,000 engines, worth over US$700 billion, will be required for more than 60,000 commercial aircraft and business jets. The forecast predicts faster growth rates for long-haul markets and those markets to, from and within Asia. These markets will continue to benefit from more liberal air service agreements, which boost demand. Factors affecting demand include GDP growth, aircraft productivity, operating costs, environmental issues and the number of aircraft retirements. While the market can be temporarily disrupted by external events, such as war, acts of terrorism, or economic downturns, it has, in the past, always returned to its long-term growth trend. In addition to the demand for engines, the Group forecasts a market opportunity worth US$550 billion for the provision of product-related aftermarket services. Defence aerospace The Group forecasts that demand for new military engines and through-life support will be worth US$450 billion over the next 20 years. The largest single market is expected to be the US, followed by Europe and the Far East. Within Asia, demand will be dominated by Japan, South Korea and India. Trends are driven by the scale of defence budgets and geopolitical developments around the world. As in the Group's other business sectors, programme lives are long and there is a significant opportunity to support equipment with aftermarket services. Customers' budget constraints and their need to increase the value they derive from their assets have accelerated the move in this direction. Marine The Group forecasts demand for marine power and propulsion systems of US$200 billion over the next 20 years. Demand will be greatest in the commercial sector, where the merchant market represents 40 per cent of the total and the offshore market, a further 40 per cent. Commercial shipping plays a crucial role in the world economy. The need to transport raw materials, finished goods, people, and oil and gas requires a large fleet which has to be renewed progressively. The expansion of trade and technological advances means more ship construction for growth and for replacement as older designs become obsolete. Finding and extracting oil and gas offshore requires a large number of floating drilling and production units which, in turn, are supported by a variety of service craft. Merchant and offshore markets are rarely at the same stage of the business cycle, which helps to reduce overall volatility. In naval markets, the Group expects surface vessels to represent 15 per cent of the total demand, and submarines five per cent. Naval markets are driven by different considerations, with customers looking to get more for their budgets, leading to increasing demand for integrated systems and through-life servicing arrangements. As in the Group's other markets, marine aftermarket services are expected to generate significant demand, forecast at US$120 billion over the next 20 years. Energy The International Energy Agency has forecast that over the next 20 years, the worldwide demand for oil will grow by 40 per cent, for gas by more than 50 per cent and for power generation by nearly 60 per cent. To satisfy this demand, there will be a growing requirement for aero derivative gas turbines. The Group's 20 year forecast values the total aero derivative gas turbine sales in the oil and gas and power generation sectors at US$70 billion. Over this period, demand for associated aftermarket services is expected to be around US$50 billion. While the oil and gas market is large and growing, demand for aero derivative gas turbines in the power generation segment is four times that of oil and gas. Note: A long-term conversion rate has been used where necessary in order to present all figures in US$. Group financial highlights The Group delivered underlying organic sales growth across all businesses, growth in underlying profits and a further year of positive cash flow. Key performance indicators The Board uses a range of financial and non-financial indicators to monitor Group and segmental performance in line with the strategy described on page 12. These indicators are chosen to monitor both current performance and the success of investments that will sustain and enhance future performance. Key performance indicators are included in the appropriate sections of the business review and are as follows: Underlying revenue Monitoring of revenues provides a measure of business growth. Underlying revenues are used in order to eliminate the effect of the decision not to adopt hedge accounting and to provide a clearer year-on-year measure. The Group measures foreign currency sales at the actual exchange rate achieved as a result of settling foreign exchange contracts from forward cover. Underlying profit before financing Underlying profit before financing is presented on a basis that shows the economic substance of the Group's hedging strategies in respect of the transactional exchange rate and commodity price movements. In particular, (a) revenues and costs denominated in US dollars and euros are presented on the basis of the exchange rates achieved during the year, (b) similar adjustments are made in respect of commodity derivatives, and (c) consequential adjustments are made to reflect the impact of exchange rates on trading assets and liabilities and long-term contracts on a consistent basis. The derivation of underlying profit before financing is shown in note 2 on page 99 of the consolidated financial statements. Cash flow In a business requiring significant investment, the Board monitors cash flow to ensure that profitability is converted into cash generation, both for future investment and as a reward for shareholders. The Group measures cash flow as the movement in net funds/debt during the year, after taking into account the value of derivatives held to hedge the value of balances denominated in foreign currencies. The figure in 2007 is shown after reflecting a Â£500 million special contribution to the Group's UK pensions schemes, as part of the restructuring of its pensions schemes. Return on capital employed Return on capital employed is calculated as the after-tax underlying profit, divided by the average net assets during the year, adjusted for net cash, the net post-retirement deficit and goodwill previously written off. It represents a measure of the return the Group is making on its investments. Net research and development change Investment in research and development underpins all the elements of the Group's strategy. Programme expenditure is monitored in conjunction with a gated review process on each programme and progress is reviewed at key milestones. Gross research and development expenditure The Group's research and development activities comprise both self-funded and customer-funded programmes. Gross expenditure measures the total research and development activity and is an indicator of the effectiveness of the actions taken to continuously improve the Group's intellectual property. Net research and development expenditure as a proportion of underlying revenue Research and development is measured as the self-funded expenditure before both amounts capitalised in the year and amortisation of previously capitalised balances. The Group expects to spend approximately five per cent of revenues on research and development although this proportion will fluctuate annually depending on the stage of development of current programmes. This measure reflects the need to generate current returns as well as to invest for the future. Capital expenditure To deliver on its commitments to customers, the Group invests significant amounts in its infrastructure. All investments are subject to rigorous review to ensure that they are consistent with forecast activity and will provide value for money. Annual capital expenditure is measured as the cost of property, plant and equipment acquired during the period. Order book The order book provides an indicator of future business. It is measured at constant exchange rates and list prices and includes both firm and announced orders. In civil aerospace, it is common for a customer to take options for future orders in addition to firm orders placed. Such options are excluded from the order book. In defence aerospace, long-term programmes are often ordered for only one year at a time. In such circumstances, even though there may be no alternative engine choice available to the customer, only the contracted business is included in the order book. Only the first seven years' revenue of long-term aftermarket contracts is included. Training and development Training is a core element of the Group's investment in its capability and is measured as the expenditure on the training and development of employees, customers and suppliers. Effectiveness is ensured by using a range of external and internal sources, and by gathering user feedback. Employee engagement Regular surveys are undertaken to identify and address emerging issues. A full employee engagement survey is run every two years with smaller pulse surveys in between. Training and employee engagement surveys are discussed further in the corporate responsibility section of this review. Sales per employee A measure of personnel productivity, this indicator measures published revenue generated per employee. Product cost index Unit costs are a key determinant of the Group's ability to deliver its commitments on a profitable basis. The Group monitors the year-on-year change in the actual average unit product cost of its gas turbine operations and seeks over time to improve productivity in all owned facilities and those of its suppliers. Engine deliveries The Group's installed engine base represents an opportunity to generate future aftermarket business. This is measured as the number of Group products delivered during the year within each business except for marine, as its products do not lend themselves to this measure due to their diversity. Installed thrust - civil Installed thrust is the indicator of the amount of product in use by our customers and therefore the scale of opportunity this presents for our services business. Percentage of civil fleet under management Long-term contracts are an important way of generating value for customers. The percentage of fleet under management gives a measure of the proportion of the installed base where the future aftermarket arrangements are agreed under long-term contracts. This is measured as the percentage of gas turbines and submarine propulsion units where the Group has contracted a long-term service arrangement. In civil aerospace, marine and energy, the percentage is weighted to reflect the value of the equipment under management. The figure shown for civil aerospace for 2004 differs from that disclosed in the Annual report for that year as a result of reflecting this weighting. Underlying services revenue Underlying services revenue shows the amount of business during the year that has been generated from the installed engine base. This is measured as the revenue derived from spare parts, overhaul services and long-term service arrangements. Emissions Much of the research and development expenditure is focused on reducing emissions of the Group's products. The Group measures both the emissions of its products and the emissions of its manufacturing operations. These measures are described in detail in the environment report, `Powering a better world', which is available on the Group's website, www.rolls-royce.com. Principal risks and uncertainties The Group continues to be exposed to a number of risks and has an established, structured approach to identifying, assessing and managing those risks. The risk committee has accountability for the system of risk management and reports regularly to the Board on the key risks facing the business and the mitigating actions put in place to deal with them. The Group's consistent strategy and long-term programmes require that key sources of risk are identified in advance and are maintained under continuous review. The risks described below are among those that the Group considers might have an impact on the Group's performance. This is notwithstanding other risks and uncertainties that are currently unknown to the Group or which the Group does not presently consider to be material. The principal risks reflect the global growth of the business, and the competitive and challenging business environment in which it operates. Risks, including those to the Group's reputation, are considered under four broad headings: - Business environment risks - Strategic risks - Financial risks - Operational risks Business environment risks Cyclical downturn - global recession The current challenging economic environment is a source of some uncertainty for the Group. The length and depth of the current recession and constraints caused by reduced liquidity from global capital markets may hinder the ability of customers and suppliers to make planned investments in all sectors. The Group's largest market, civil aerospace, is cyclical by nature, although services activity and revenues, now representing more than 60 per cent of the civil aerospace business annual revenue, have historically been less volatile in economic slowdowns and are considered more predictable and robust than the sales of engines for new aircraft. The contribution from the Group's global activity in other non-civil aerospace markets is becoming more significant. It now represents around 50 per cent of Group revenues, and these markets are also less cyclical in nature. The Group's broadly balanced power systems activities, access to global markets with greater diversification by sector, customer and geography and an improved balance between original equipment and services revenues are expected to help mitigate the effects of the slowing global economy. The Group has a robust balance sheet with positive net cash. The changes made to the UK defined benefit pension schemes should ensure a less volatile, more predictable funding requirement in the future. External events or factors affecting air travel The civil aerospace business remains an important contributor to the Group's revenues and profits. The willingness of passengers to travel by air is influenced by a range of factors, including economic conditions, health and security issues. Any prolonged reduction in air travel would impact airlines' revenues and cash flows, and potentially reduce their need for new engines, spare parts or aftermarket support services. Exposure to this risk is mitigated by the Group's business strategy, which has driven it to become a global operation with a broader business base, with 50 per cent of revenues and 40 per cent of earnings now generated outside the civil aerospace business from its defence aerospace, marine and energy businesses. The Group's crisis management plan and framework would be instrumental in responding to, and recovering from, wider external events such as the impact of terrorist activity or an influenza pandemic. Environmental impact of products and operations The Group recognises that its products and business operations have an impact on the environment, particularly related to climate change. Rolls-Royce is determined to be part of the solution to these environmental challenges and continues to make significant investment in innovative solutions for the aviation, marine and energy markets. The challenge is being addressed through the enhancement of current product ranges and affordable research and development into complementary technologies such as nuclear power, fuel cells and tidal energy. The Group continues to work closely with its customers, industry partners and other stakeholders to implement these development opportunities. A robust governance structure headed by the Environment Council directs and monitors improvements in the environmental performance of the Group's products, and the Environmental Advisory Board reviews and makes recommendations on the environmental aspects of the Group's products and business operations (see pages 42 to 53). Strategic risks Delivery of aftermarket The Group's revenues are balanced between original equipment delivery and aftermarket services. The growth in product sales provides a large installed base, of which a high proportion has successfully been contracted under long-term post-sale support arrangements, so that aftermarket revenues now constitute a majority of forecast revenue. A significant failure to deliver the aftermarket commitments made to its customers and meet anticipated contractual profitability could have an adverse impact on the Group's financial results and reputation. The Group places great importance on working closely in partnership with its customers to understand their operations and align the Group's service capability to meet their needs. Within the dedicated services organisation, management initiatives have developed robust processes, structures and networks to ensure required support levels can be delivered effectively and economically. Nevertheless, economic pressures on commercial aviation, as well as changes in regulations, could lead to reductions in utilisation rates and operational budgets, representing a continuing threat to the realisation of future revenues. Competitive pressures The markets in which Rolls-Royce operates are highly competitive. The majority of its programmes are long term in nature and access to key platforms is critical to the success of the business. This requires sustained investment in technology, capability and infrastructure, all creating high barriers to entry. However, these factors alone do not protect the Group from competition, including pricing and technical advances made by competitors. The Group has developed a balanced business portfolio and maintained a steady focus on improvement in operational performance, for example through the modernisation of its facilities. This, together with the establishment of long-term customer relationships and sustained investment in technology acquisition, allows the Group to respond to competitive pressures. Export controls Rolls-Royce designs and supplies a number of gas turbine products and services for the defence aerospace market. Many countries in which the Group conducts its business operate legislation controlling the export of specified goods and technology intended or adaptable for military application. The Group is committed to complying with the requirements from national governments in all jurisdictions when exporting goods, parts, technologies or information, although globalisation of the Group's operations brings with it complexities of concurrent but differing national export control legislation. Non-compliance with export controls is recognised as a principal risk to both programme performance and the Group's reputation. The exports committee, chaired by the Chief Operating Officer, directs the Group's strategy and policy on exports. Export control managers are embedded throughout the business and the Group will continue to implement any necessary changes to ensure that it maintains the capability necessary to monitor and comply with requirements. Financial risks These are risks that arise as a result of movements in financial markets. Principal risks are: - movements in foreign currency exchange rates; - interest rates; - commodity prices; and - counterparty credit risk. A description of these risks and details of the Group's risk mitigation actions in this area are provided in the Finance Director's review. Operational risks Performance of supply chain The Group's products and services are delivered through the effective operation of its facilities and key capabilities, including its supply chain. The Group's success in strengthening its market position places increased reliance on the performance of the supply chain. The Group manufactures approximately 30 per cent by value of its gas turbine products, the remainder being provided through external suppliers, including risk and revenue sharing partners. Meeting delivery commitments on schedule, cost and quality are critical to the achievement of business goals. The Group has a consistent focus on cost reduction and performance improvement and it continues to modernise its production facilities to improve productivity and reduce costs. Investment in developing world-class manufacturing processes is continuing in Asia, North America and Europe. This also drives development of the external supply chain through sourcing of parts from many new countries. Global supply chains are inevitably complex with numerous inter-relationships with a wide variety of organisations. While the Group's strategy is to improve integration and simplify the internal and external elements of its supply chain by building strategic links with fewer, stronger suppliers, it is still prone to disruption from financial or physical causes. A major disruption in any of these elements would adversely affect the Group's ability to deliver its operational commitments and would have the potential to affect financial returns. The planning for, and management of, any such interruption is addressed through the Group's business continuity management process. Substantial progress has been made in the deployment of business continuity management systems and structures to assess the likelihood and potential impacts of a catastrophic disruption to the Group's key facilities. In addition to the Group's comprehensive programme of business interruption insurance, significant investment is being undertaken to establish, where possible, dual sourcing of key components. Increased focus is also being applied to understanding and addressing sources of risk arising in the external supply chain, particularly those associated with financial instability. Procedures are in place to monitor, assess and respond in such circumstances. IT security The continuing globalisation of the business and advances in technology have resulted in more data being transmitted across international communication links, posing an increased security risk. There is also the possibility of unintentional loss of controlled data by authorised users. In either case, adverse impacts upon operational effectiveness, the value of intellectual property, legislative compliance or the reputation of the Group might arise. The active sharing of information through industry and government forums and the continual upgrading of security equipment and software mitigate these risks. Ethics The Group recognises the benefit that is derived from conducting business in an ethical and socially responsible manner. This approach extends from the sourcing of raw materials and components to the manufacture and delivery of products and services. It applies to the provision of a safe and healthy place of work and investment in technologies to reduce the environmental impact of the Group's products and operations. Shortcomings in any of these areas could damage the Group's reputation and disrupt its business. The Group is committed to maintaining high ethical standards. A global code of business ethics has been issued to employees and a face-to-face training and engagement programme is in place in order to strengthen employee awareness of the Group's values. The Group's ethical standards are also communicated to the Group's first-tier supply base through a supplier code of conduct. Concerns regarding potentially unethical behaviours can be reported in confidence via dedicated global telephone and internet channels. All such reports are followed up and will be monitored by the recently formed ethics committee. Programme risk The Group manages complex product programmes with demanding technical requirements against stringent, and sometimes fluctuating, customer schedules. This requires the co-ordination of the engineering function, manufacturing operations, the external supply chain and other partners. Failure to achieve programme goals would have significant financial and reputational implications for the Group. The Group seeks continuous improvement of all its processes and employs project management controls on a routine basis. All major programmes are subject to Board approval and are reviewed regularly by the Board with a particular focus on the nature and potential impact of emerging risks and the effective mitigation of previously identified threats. Review of operations Key businesses and activities We focus on investing in technology and capabilities that can be successfully applied to our advanced products and services. We then market and sell these through our four main customer facing businesses: civil aerospace, defence aerospace, marine and energy. Our manufacturing base is becoming increasingly global, as is our supply chain, as we seek to bring our products to market in the most efficient way. We have established a global service organisation with more than 50 locations around the world to bring us closer to our customers. This section of the report reviews the year for each of the customer facing businesses, including our services activity, and the key functions of engineering and operations. Civil aerospace - Agreements signed with risk and revenue sharing partners for 40 per cent of Trent XWB programme - Trent 1000 ready for first flight of Boeing 787 - Successful entry into service of Trent 900 with Singapore Airlines and Qantas on the Airbus AFF80 - Successful entry into service of IAE V2500 SelectOneTM - Successful first run of BR725 for the new Gulfstream G650 Key financial data 2008 2007 2006 2005 2004 _________________________________________ ____ ____ ____ ____ ____ Underlying revenue Â£m 4,502 4,038 3,907 3,406 3,072 +11 % +3 % +15 % +11 % +13 % _________________________________________ ____ ____ ____ ____ ____ Underlying profit before financing Â£m 566 564 519 454 208 +0 % +9 % +14 % +118 % +24 % _________________________________________ ____ ____ ____ ____ ____ Net assets Â£m 330 2,468 2,165 1,617 1,740 _________________________________________ ____ ____ ____ ____ ____ Other key performance indicators _________________________________________ ____ ____ ____ ____ ____ Order book Â£bn 43.5 35.9 20.0 19.0 16.2 +21 % +80 % +5 % +17 % +13 % _________________________________________ ____ ____ ____ ____ ____ Engine deliveries 987 851 856 881 824 _________________________________________ ____ ____ ____ ____ ____ Underlying services revenues Â£m 2,726 2,554 2,310 2,016 1,838 _________________________________________ ____ ____ ____ ____ ____ Underlying services revenues % 61 63 59 59 60 _________________________________________ ____ ____ ____ ____ ____ % of fleet under management 57 55 48 45 45 _________________________________________ ____ ____ ____ ____ ____ Underlying revenue Â£4.5bn Market opportunity over 20 years US$1,250bn The civil aerospace business powers over 30 types of commercial aircraft from business jets to the largest widebody airliners. A fleet of over 12,000 engines is in service with 600 airline customers and 4,000 corporate operators. The business continued to perform strongly in 2008 despite the impact of worsening economic conditions on customers and on the air travel market in general. Underlying revenue grew by 11 per cent. This result was driven by increases in new engine deliveries, which approached 1,000 units, and by continued growth of services revenues which accounted for over 60 per cent of total sales. The first half of 2008 continued to see strong order intake and, while order activity slowed in the second half of the year, the total order book for civil aerospace grew to Â£43.5 billion. Underlying profit was flat year-on-year. In the corporate and regional market, the 3,000th AE 3007 engine was delivered. Meanwhile, the newest member of the Group's corporate engine family, the BR725 for the new Gulfstream G650 corporate aircraft, achieved first engine run on time in April. The G650 has enjoyed unprecedented market interest, reinforcing the Group's leading position in the corporate market. V2500 SelectOne, the latest successful V2500 engine standard, produced by the International Aero Engines (IAE) consortium, in which Rolls-Royce is a major shareholder, entered service with IndiGo Airlines of India. The Trent family continues to enjoy significant success. The Trent 900-powered Airbus AFF80 completed a year of service and demonstrated excellent reliability with Singapore Airlines (SIA) and Qantas. Further orders for the engine were received from SIA and Thai Airways International. The Trent 900 has now been selected by ten of the 13 operators that have ordered the AFF80 and made an engine decision. The Trent 700 continued to win over 70 per cent of orders placed for the Airbus AFF30. Significant additional orders were also placed for the Trent 1000 for the Boeing 787, which has now been selected by about 50 per cent of operators, and for the Trent XWB, which is currently the only engine offered for the Airbus AFF50 XWB. Entry into service of the Boeing 787 has been delayed until 2010, but maturity testing of the Trent 1000 has continued with successful demonstration of endurance programmes equivalent to two years of service. The Trent XWB programme attracted considerable interest from risk and revenue sharing partners with agreements signed by the end of 2008 for around 40 per cent of the programme, with major partners including KHI and MHI of Japan, ITP of Spain, Volvo of Sweden, Hispano-Suiza of France and Parker Hannifin of the US. We continued to secure services contracts, achieving a record year for CorporateCareTM sales and selling TotalCareTM with approximately 90 per cent of new Trent engine orders. A larger Operations and Data Centre was opened in September to support the growing large-engine fleet under Rolls-Royce service contracts, now totalling 5,300 engines. We are actively exploring technologies and programmes that address environmental and sustainability issues relevant to our business. Through our Option 15-50 programme we continue to pursue a comprehensive range of leading technologies and engine architectures to meet these challenges. Global air travel and air freight is already being affected by the economic downturn. The scale of the future impact is unclear, with airframe delays and concerns about customer financing adding to the uncertainties surrounding engine volumes. The Group expects engine deliveries to fall in 2009 with an increasing risk of deferrals and cancellations, weaker volumes in the narrowbody and the corporate and regional sectors, and stable Trent deliveries for widebody aircraft. Growth in services revenues will be modest in 2009, held back by lower utilisation levels, the impact of parked aircraft and some softening of uncontracted `Time and Material' services revenues. As a consequence, underlying profits will be lower in 2009. Defence aerospace - Â£700 million contract secured for UK strategic tanker aircraft - US$915 million contract for AE 2100 engines signed with Alenia - Development of the F136 engine for the F-35 funded for 2009 - US$131 million F-35 Rolls-Royce LiftSystemÂ® contract awarded - Â£258 million service and support contract for Gnome helicopter engines - Â£198 million contract to support UK Pegasus engine fleet Key financial data 2008 2007 2006 2005 2004 _________________________________________ ____ ____ ____ ____ ____ Underlying revenue Â£m 1,686 1,673 1,601 1,420 1,374 +1 % +4 % +13 % +3 % -2 % _________________________________________ ____ ____ ____ ____ ____ Underlying profit before financing Â£m 223 199 193 180 179 +12 % +3 % +7 % +1 % +22 % _________________________________________ ____ ____ ____ ____ ____ Net assets Â£m (197 ) (172 ) 20 55 131 _________________________________________ ____ ____ ____ ____ ____ Other key performance indicators _________________________________________ ____ ____ ____ ____ ____ Order book Â£bn 5.5 4.4 3.2 3.3 3.3 +25 % +38 % -3 % 0 % +22 % _________________________________________ ____ ____ ____ ____ ____ Engine deliveries 517 495 514 565 548 _________________________________________ ____ ____ ____ ____ ____ Underlying services revenues Â£m 947 877 853 787 768 _________________________________________ ____ ____ ____ ____ ____ Underlying services revenues % 56 52 53 55 56 _________________________________________ ____ ____ ____ ____ ____ % of fleet under management 12 11 11 8 5 _________________________________________ ____ ____ ____ ____ ____ Underlying revenue Â£1.7bn Market opportunity over 20 years US$450bn Rolls-Royce is Europe's largest defence aero-engine company, serving 160 customers in 103 countries and with 18,000 engines in service. We have a product range of 25 engines that power aircraft across the key market sectors of combat, transport, helicopters, trainers, patrol, maritime and reconnaissance. During 2008, the business continued to strengthen its market position, winning key contracts across its product and service range, particularly in the growing transport aircraft and military support sectors. This included the development of our innovative range of aftermarket services, known as MissionCareÂ®, which enables Rolls-Royce to tailor support services solutions to customers' individual requirements. The new operations facility in Bristol, UK, opened in the first quarter of 2008. It delivers a step change in engine assembly, development and logistics and, in combination with more flexible working practices, brings greater effciencies to the manufacturing process. In the combat aircraft market, the EJ200 powerplant for the Typhoon aircraft achieved several landmarks, with the 500th engine delivery and 100,000 flying hours in operational service. We also made progress on both engine programmes for the Joint Strike Fighter. First flight of the F-35 STOVL (short take off and vertical landing) version, fitted with the Rolls-Royce LiftSystemÂ®, took place in May and the first LiftSystem production contract was secured in December at a value of US$131 million. The F136 engine, jointly developed with GE for all F-35 variants, achieved US Government funding for 2009 and passed its test milestones prior to delivery of the first production standard engine in early 2009. We also consolidated our market lead in the transport aircraft market, signing a US$915 million agreement with Alenia Aeronautica for the AE 2100 engine in the C-27J military transport aircraft. This engine also won further orders for its application in the C-130J. Defence aerospace's other major collaborative programme - the TP400 engine for the A400M military transport aircraft - made progress in the year. It has completed more than 2,000 hours of ground testing and has successfully undertaken its first flights on the flying testbed. As a shareholder and sub-contractor of the AirTanker consortium, we secured a 27-year engine and support contract worth over Â£700 million from the UK Ministry of Defence (MoD) for the UK's Future Strategic Tanker Aircraft under an innovative private finance scheme. This Airbus AFF30M aircraft is powered by the civil Trent 700, representing new aftermarket opportunities for this engine in a defence environment. Orders for our innovative aftermarket solutions included a US$90 million engine availability contract for the T-45 Goshawk trainer with the US Navy, and the UK MoD's first full availability contract to support its Gnome-powered Sea King helicopter fleet at a value of Â£258 million. In the helicopter sector, the RR300 was certified ahead of schedule and the first Rolls-Royce Honeywell LHTEC T800 engine was delivered to AgustaWestland for the UK Future Lynx Battlefield Reconnaissance programme. Looking to the future, we are working on two important research and technology programmes for the US Air Force, Adaptive Versatile Engine Technology (ADVENT) and the Highly EFFcient Embedded Turbine Engine (HEETE). In the unmanned vehicle sector, we have been selected to provide the Integrated Power System for the UK's Mantis demonstrator, while we continue to work on the MoD Taranis unmanned combat vehicle demonstrator. The Rolls-Royce AE 3007 engine, which powers the Global Hawk high altitude unmanned aerial reconnaissance system, was selected for the new US Broad Area Maritime Surveillance programme. Significant opportunities exist in the global defence market, particularly in the combat, transport, unmanned and helicopter sectors. The business also continues to develop innovative aftermarket solutions, with services now generating over 50 per cent of sales. Further strong growth in engine deliveries for the military transport sector is expected to support another year of profit growth in 2009. Marine - Â£901 million of sales in the offshore sector - Â£96 million contract to power new Royal Navy aircraft carriers - Order book grown to Â£5.2 billion - Major global services expansion now under way Key financial data 2008 2007 2006 2005 2004 __________________________________________ ____ ____ ____ ____ ___ Underlying revenue Â£m 2,204 1,548 1,299 1,097 963 +42 % +19 % +18 % +14 % -4 % __________________________________________ ____ ____ ____ ____ ___ Underlying profit before financing Â£m 183 113 101 89 78 +62 % +12 % +13 % +14 % 0 % __________________________________________ ____ ____ ____ ____ ___ Net assets Â£m 488 563 619 674 651 __________________________________________ ____ ____ ____ ____ ___ Other key performance indicators __________________________________________ ____ ____ ____ ____ ___ Order book Â£bn 5.2 4.7 2.4 1.7 1.4 +11 % +96 % +41 % +21 % +17 % __________________________________________ ____ ____ ____ ____ ___ Underlying services revenues Â£m 712 545 487 435 397 __________________________________________ ____ ____ ____ ____ ___ Underlying services revenues % 32 35 37 40 41 __________________________________________ ____ ____ ____ ____ ___ % of fleet under management 35 33 3 3 0 __________________________________________ ____ ____ ____ ____ ___ Underlying revenue Â£2.2bn Market opportunity over 20 years US$320bn Marine is now the second largest Rolls-Royce business in revenue terms, with a world-class range of capabilities and expertise in naval surface ships, submarines, offshore oil and gas and merchant vessels. It has equipment installed on over 30,000 vessels, including those of 70 navies, representing a major opportunity for services growth. The marine business has enjoyed a year of very strong growth. Our revenues since 2005 have doubled and increased by 42 per cent on 2007, driven by continuing growth in our offshore business which itself grew by 38 per cent in 2008. Marine profit has also increased by 62 per cent in 2008. As our installed base of equipment grows, we are expanding our services capability and investing in new service centres globally to realise the significant opportunity that this represents. In addition, the expertise established in our aerospace businesses, including equipment health monitoring and long-term service agreements, is being applied to further increase marine's service revenues. The offshore sector has been central to our 2008 performance, based on the success of our specialist UT-Design and integrated systems capability which is the industry benchmark. Driven by significant investment in deep water exploration and production by the oil and gas industry, the sector has generated record sales of Â£901 million in 2008. We have been particularly successful in the Asian offshore market, winning orders valued at Â£666 million in 2008 including contracts worth Â£84 million to supply propulsion equipment for offshore vessels being built in China and Korea. Two further landmark orders were received from China: a Â£58 million contract with China Oilfield Services Ltd and a Â£13 million contract with BGP Marine China to design and equip an advanced seismic research vessel. During 2008, we acquired Scandinavian Electric Holding, which has further increased our capability in the design and supply of power electric systems. This enhances our ability to provide systems for offshore vessels, thereby increasing our overall market size. Our proven offshore system capabilities are also being utilised in the development of specialist merchant ships, such as the contract to design and power two vessels for Sea-Cargo AS which will be equipped with innovative gas-fuelled Bergen engines. Our naval business also won a milestone order in 2008: a Â£96 million contract to provide power and propulsion equipment, including four MT30 gas turbines, for the UK's new aircraft carriers. As part of the Carrier Alliance, Rolls-Royce is supplying an integrated system which includes the propellers and propeller shafts as well as rudders, stabilisers and some electrical systems. 2008 was the 50th anniversary of our relationship with the UK Government on the design, production and support of nuclear plant for the Royal Navy's submarine fleet. The submarines business is primarily focused on service and support, underpinned by an innovative Â£1 billion service contract with the MoD signed in 2007. In 2009, marine will establish a global headquarters in Singapore which will enhance our global position and bring us closer to key customers in Asia. There were some modest cancellations in 2008 but a record order book, market leading positions in the offshore sector and demand for high specification vessels provide good visibility of revenues in 2009 and support continuing strong growth in profitability over the year. Energy - Industrial Trent achieved record sales of over US$380 million - Services business had record year with over 200 gas turbine packages now under TotalCare contracts - Civil nuclear business established to address the growing global market - Significant investment in production and test facilities Key financial data 2008 2007 2006 2005 2004 __________________________________________ ___ ___ _____ ___ ___ Underlying revenue Â£m 755 558 546 535 538 +35 % +2 % +2 % -1 % +2 % __________________________________________ ___ ___ _____ ___ ___ Underlying profit before financing Â£m (2 ) 5 (18 ) 1 (7 ) -140 % +128 % -1900 % +114 % +61 % __________________________________________ ___ ___ _____ ___ ___ Net assets Â£m 392 370 387 390 453 __________________________________________ ___ ___ _____ ___ ___ Other key performance indicators __________________________________________ ___ ___ _____ ___ ___ Order book Â£bn 1.3 0.9 0.5 0.4 0.4 +44 % +80 % +25 % 0 % 0 % __________________________________________ ___ ___ _____ ___ ___ Engine deliveries 64 32 44 61 47 __________________________________________ ___ ___ _____ ___ ___ Underlying services revenues Â£m 370 289 251 219 248 __________________________________________ ___ ___ _____ ___ ___ Underlying services revenues % 49 52 46 41 46 __________________________________________ ___ ___ _____ ___ ___ % of fleet under management 9 7 6 5 5 __________________________________________ ___ ___ _____ ___ ___ Underlying revenue Â£0.8bn Market opportunity over 20 years US$120bn The energy business is a world-leading supplier of power systems for onshore and offshore oil and gas applications, and has a growing presence in the electric power generation sector. It supplies products to customers in over 120 countries. Order intake remained strong in 2008, with services once again posting a record year and continuing to account for nearly 50 per cent of total energy sales. African and Asian oil and gas markets were particularly active in 2008, with eight RB211 packages ordered for installation off the shores of West Africa, and six new compression sets for pipeline service in India. Other oil and gas RB211 packages were ordered for customers in China, Malaysia and Algeria. Of particular significance was a year-end order, for eight Rolls-Royce driven compression sets from a unit of the Russian natural gas company, Gazprom. The new packages will be installed on the Nord Stream pipeline project running under the Baltic Sea from Russia to Germany. They are scheduled for delivery in 2010, with service expected to start in late 2011. Market acceptance of the industrial Trent drove another record year in the global power generation sector, with orders received in excess of US$270 million. These included 13 Trents for power generation service in Australia, Belgium, the Czech Republic, Germany, Hungary, New Caledonia and Slovakia. In North America, we continued to establish the Trent's growing footprint in the high-demand north east US power generation market. Successful start-up and commissioning was completed for a Trent genset package at Lowell, Massachusetts, while construction continues for two Trent units at Braintree, Massachusetts for which start-up is scheduled in the second quarter of 2009. Reservations for an additional 18 Trent units in North America were also received. The aftermarket business experienced another record year in 2008 with sales of Â£370 million. Over 200 Rolls-Royce gas turbine packages were covered by TotalCare agreements by year-end; this number is expected to increase to over 250 by mid-2009. Our product upgrades business also delivered another strong year, enhancing customer value by applying new gas turbine technology to increase the efficiency and power of in-service units. Over 40 Avon 200 gas turbine upgrades have been delivered over the past two years to increase the power and efficiency of these highly reliable machines, while demand for control system and centrifugal compressor upgrades also continues to grow as a result of enhanced product performance benefits. As part of our strategy to accommodate growing production volume efficiently, we consolidated packaging operations into our Mount Vernon, Ohio facility and ceased operations at our Liverpool, UK facility. Two new lean assembly flow lines, dedicated to Trent and RB211 packages, were opened in 2008, and construction began on seven new gas turbine test beds which will become operational in the second quarter of 2009. In 2009, further growth in original equipment revenues, particularly in the power generation sector, combined with increased services activity and lower investment in fuel cells, is expected to deliver a modest level of profit for the business. While our energy business currently centres on the gas turbine, the skills and technical knowledge within the Group allow us to identify and explore new growth opportunities in the energy market. The most significant of these in the near term is civil nuclear, where, through our experience of manufacturing and supporting nuclear reactors for the Royal Navy's submarine fleet, we have a strong and unique capability. In 2008, we established a new business to address the market arising from renewed global demand for nuclear power. Engineering and Technology - Global research network expanded - Further research work in US secured - Europrop International TP400 flew for the first time - WR-21, the world's most efficient marine gas turbine, entered service - Trent 60 WLE dual fuel started service operation Key performance indicators 2008 2007 2006 2005 2004 __________________________________________ ___ ___ ___ ___ ___ Gross research and development expenditure Â£m 885 824 747 663 601 __________________________________________ ___ ___ ___ ___ ___ Net research and development expenditure Â£m 490 454 395 339 282 __________________________________________ ___ ___ ___ ___ ___ Net research and development charge Â£m 403 381 370 282 288 __________________________________________ ___ ___ ___ ___ ___ Net research and development expenditure % of underlying revenue 5.4 5.8 5.4 5.2 4.7 __________________________________________ ___ ___ ___ ___ ___ The Group's engineering and technology activity includes our research and technology, product development and product upgrade operations across our four customer-facing businesses. We have 9,600 people in our worldwide engineering network, with major centres in the UK, USA, Canada, Germany, Scandinavia, India and Singapore. In addition, the Group leverages resources through its global network of 29 University Technology Centres (UTC) in seven countries, which develop and acquire technologies for tomorrow's Rolls-Royce products. This network further expanded in 2008 with the opening of a UTC in Pusan, Korea, to develop high efficiency heat exchangers. In 2008, we have continued to invest in a broad range of technology development and demonstration programmes. Research and development expenditure was Â£885 million, of which Â£490 million was funded from Group resources. The net charge to the income statement was Â£403 million. A significant proportion of this technology provides the foundation for products with reduced environmental impact while delivering increased value to our customers. Building on our past research successes we filed 425 patent applications in 2008, a record year for the Group. We have made good progress on two US Air Force premier technology programmes, ADVENT and HEETE, and won a further award for the Integrated Vehicle Energy Technology (INVENT) programme. In Europe, we successfully ran the Power Optimised Aircraft (POA) engine demonstrator, integrating electrically driven engine components which traditionally are powered mechanically. We also achieved encouraging noise level results from a rig test demonstrating the open rotor aero engine, which has the potential to deliver a step reduction in fuel consumption. We continued, with partners, to develop two low-carbon energy technologies. The construction of the 500kW underwater tidal power turbine prototype has started and we also began system testing our solid oxide fuel cells. However, we have taken the decision to focus future fuel cells activity on the development of the technology rather than production and manufacturing verification in order to match product readiness with market demand. Our focus on modern manufacturing continues with the opening of the Factory of the Future, the latest development of the Advanced Manufacturing Research Centre in Sheffield, UK. We are also making good progress on the Advanced Forming Research Centre in Glasgow, UK, and three other manufacturing research centres globally. In defence aerospace, the Rolls-Royce LiftFan flew on the Joint Strike Fighter in conventional mode, ahead of full system testing in 2009. The TP400, developed by the Europrop International consortium, for the A400M military transport aircraft, flew for the first time on the flying testbed. In civil aerospace, the Trent 900 demonstrated excellent reliability during its first full year in service with Singapore Airlines and is also in operation with Qantas. The Trent 1000 continues to build its maturity on the test bench, awaiting first flight of the Boeing 787. The first BR725 for the Gulfstream G650 ran on time and the engine is making good progress towards certification. The Trent XWB for the Airbus AFF50 XWB has now largely completed its preliminary design stage. Our drive for improved in-service engine reliability continues, with engine health monitoring data and analysis techniques delivering globally competitive and improving levels of fleet reliability. HMS Daring, the first of the WR-21 powered Royal Navy Type 45 destroyers, was handed over to the Royal Navy in 2008. The engine, with its intercooled and recuperated cycle, is the world's most efficient marine gas turbine. The Littoral Combat Ship USS Freedom was commissioned for US Navy service, demonstrating successful integration of two MT30s, the most powerful marine gas turbine in the world, derived from the Trent 800 aero engine. The MT30s together with four Rolls-Royce Kamewa 153 S11 waterjets drive this 3,000 tonne ship at speeds in excess of 40 knots. The long life nuclear core was successfully installed in the first Astute class submarine for the Royal Navy. With this reactor core the submarine can operate for its whole lifespan without refuelling. Operations - Increased demand from all businesses managed effectively by the supply chain - New product introductions included the BR725, MT30 and JSF LiftSystem - Successfully rephased production on Trent 900 and Trent 1000 programmes - Underlying revenues per employee up 18 per cent - New joint ventures signed with both GKN plc and Goodrich Corporation Key performance indicators 2008 2007 2006 2005 2004 _______________________________________ ___ ___ ___ ___ ___ Capital expenditure Â£m 283 304 303 232 191 _______________________________________ ___ ___ ___ ___ ___ Product cost index - year-on-year (increase)/decrease % (4 ) (7 ) (5 ) 0 5 _______________________________________ ___ ___ ___ ___ ___ Sales per employee Â£'000 233 193 192 186 169 _______________________________________ ___ ___ ___ ___ ___ Our supply chain provides parts for both the original equipment and aftermarket areas of our business. It responded extremely positively to a significant increase in demand from all sectors, supporting a growth in underlying revenue of 17 per cent in 2008. New product introductions and the impact of programme slippages were also managed effectively. Through our make/buy strategy, we continued to focus on making only those parts which are rich in intellectual property in order to maximise value. The strategy was underpinned by ongoing supply chain rationalisation and the development of strategic supplier relationships, exemplified by the agreement of risk and revenue sharing partnerships for 40 per cent of the Trent XWB programme. Business process improvements and the ongoing roll out of new process systems like SAP and PLM continued to drive operational efficiency, for example enabling the reduction of 2,300 jobs in support functions. As a result, productivity measured as underlying revenues per employee, improved by 18 per cent on 2007. Our modern domestic factories continued to improve their productivity. However, commodity prices resulted in a product cost index rise of four per cent. A range of new product introductions was managed during the year, with the first run of the BR725 engine for the Gulfstream G650, first flight of the F-35 STOVL variant for the Joint Strike Fighter (JSF) and plans established to deliver orders for the MT30 naval gas turbine and the JSF LiftSystem. We also successfully rephased our production programmes for the Trent 1000 and 900 engines in response to programme slippages on the Boeing 787 and Airbus AFF80. In the medium to long term, our record order book will drive a significant increase in the load on our supply chain, though the timing of this increased activity will be affected by programme slippages and the economic downturn. We are phasing the development of our new manufacturing facilities in Singapore and Crosspointe, US, to take account of these impacts in order to meet demand in a timely fashion. In November 2008, we announced proposed global job reductions for 2009 of around 1,500-2,000, as a result of economic uncertainties and individual programme developments. We will continue to recruit graduates, apprentices and other employees in order to support areas of particular growth. Our Business Process Improvement programme continued to direct spend on information technology. We continued to introduce our design and data management tool, PLM, and our planning and scheduling tool, SAP, notably into Hong Kong Aero Engine Services Limited (HAESL), our Hong Kong repair and overhaul joint venture. Our services processes will be further enhanced in 2009 with the application of the Maximo planning tool. We expanded our capability during the year, establishing strategic joint ventures with GKN plc, to develop composite materials for fan blades, and Goodrich Corporation, to develop and manufacture engine controls. Our success is based on operational excellence, strong partnerships and technological superiority. We would like to thank all our employees, suppliers and partners for their commitment to these core principles and for their hard work during the year. Services - Service revenues increased by 11 per cent to Â£4.8 billion - 57 per cent of the civil aerospace fleet now under TotalCare support - More than 8,000 engines and auxiliary power units covered by in-service monitoring - Expansion of joint ventures in Hong Kong and Singapore - Global repair services created, increasing focus on repair technology - Expanded capability of global Operation Centres, including satellite sites with two major customers Key performance indicators 2008 2007 2006 2005 2004 _______________________________________ _____ _____ _____ _____ _____ Underlying services revenue Â£m 4,755 4,265 3,901 3,457 3,251 _______________________________________ _____ _____ _____ _____ _____ Underlying services as percentage of Group revenue 52 55 53 54 55 _______________________________________ _____ _____ _____ _____ _____ The Group's services business includes field services, the sale of spare parts, equipment overhaul services, parts repair, data management, equipment leasing and inventory management services. These services are typically sold as a package under our TotalCare banner. Group service revenues increased by 11 per cent in 2008, driven by good progress across all sectors. Services represented 52 per cent of Group revenues. The strongest growth was recorded in marine, demonstrating the value of expanding our service network in this sector. Our latest service centre in Mumbai was opened in May and later in the year we entered into an agreement with Abu Dhabi Shipbuilders to provide waterjet services in the Middle East. During 2008, we continued to invest in our civil aerospace service network, with extensions to both Singapore Aero Engine Services Limited (SAESL) and Hong Kong Aero Engine Services Limited (HAESL) under construction. This capacity will come on stream in 2009 and 2011 respectively and is being funded without recourse to the joint venture shareholders. In its first full year of operation, the overhaul facility we have established with Lufthansa, N3, has made steady progress, successfully introducing Trent 700 capability and expanding its customer base. Our field support capability has also been enhanced with the opening of our eighth On-Wing Care centre, in Brazil, and we are developing capability in the UAE in conjunction with Mubadala Development Corporation. On-Wing Care services were provided for over 3,000 engines across the year. We have continued to expand our services provision with the successful deployment of our Electronic Flight Bag (EFB), now in its third year. The EFB provides, among other applications, a key data acquisition capability to optimise overall aircraft and fleet fuel usage. The TotalCare model encourages an integrated approach, which means we work closely with our customers to optimise the operation of their assets while carefully managing costs. We conduct in-service monitoring for over 8,300 engines worldwide, providing engine health monitoring and data analysis services in conjunction with our expanded Operations Centres. This enables real-time data acquisition and analysis to maximise operational performance for our customers in parallel with optimising support costs. We are also increasing the focus on overhaul costs, reorganising our component repair activities during the year to establish Global Repair Services. This organisation takes a strategic approach to repair development and is investing in advanced repair processes. Contract highlights for the year included agreements with US Airways to support its RB211-535 fleet with a TotalCare package and a similar contract with IAE for its V2500 fleet. TotalCare support arrangements now cover 57 per cent of the civil aerospace fleet. In defence aerospace we competed for and successfully retained the F405 US Navy contract, which we have been executing for the past five years, the new contract being for a further year with four one year extension options. Also notable were a number of helicopter contracts including a Â£258 million award from the UK MoD to support Gnome engines. In the energy business, ten long-term service agreements were won with a total value of Â£160 million. We expect to agree a further ten energy contracts covering 50 new gas turbine units that will be installed during 2009, taking the number of packages under long-term service agreements to over 250, or around 20 per cent of the fleet. The upgrade and standardisation of our IT systems to support the services business continued and underpinned our expanded-capability Operations Centre, opened in the UK during 2008. We have also defined a suite of integrated Service Life Cycle Management processes and supporting IT tools that we are rolling out Group-wide in a multi-year programme. The highlight for the year was a flawless implementation of SAP at HAESL where the site achieved near record output in the month the system went live. We remain confident that our service model is aligned with our customers' interests, encouraging us to focus on maximising the effectiveness of their assets. This alignment and focus drive the investment in capability and improved delivery that is the hallmark of our services business. Finance Director's review Andrew Shilston Introduction The progress made by the Group in 2008 should be viewed against a rapidly deteriorating external environment with significant negative pressures starting to influence many industries and companies. The Group delivered a strong 17 per cent increase in underlying revenues, a ten per cent increase in underlying profit before tax to Â£880 million and a further Â£570 million cash inflow which benefited from retranslation effects. The strong improvement in profits was achieved despite some significant headwinds, notably a further eight cents deterioration in the GBP/USD achieved rate that cost the Group Â£104 million in 2008; and there was a four per cent increase in unit costs. The published results were heavily influenced by the significant adjustments in foreign exchange rates in 2008, especially the GBP/USD and the GBP/EUR which are explained below. The Group benefited from a strong financial position and credit rating with net cash of Â£1,458 million at the year end and with average net cash throughout the year of Â£375 million. The changes made to the Group's UK pension schemes in 2007 mean that the deficit has remained stable and modest and the schemes ended the year with a net deficit of Â£142 million, as detailed in note 18 of the financial statements on page 126. The very unusual circumstances that have developed through 2008 in global debt markets have, however, caused a large, unrecognised surplus to develop on the UK defined benefit pension schemes. The redemptions on the Group's existing bond financing, at around Â£1.0 billion, are well spread with no material maturities in 2009, US$187 million due in the second half of 2010 and a 750 million note due in 2011 as shown in the chart below. The Group had a further Â£650 million in term funding available to it that was undrawn at the year end. Foreign exchange effects on published results The pace and extent of currency movements have had a significant effect on the Group's financial reporting in 2008, with the sterling exchange rate with the US dollar and the euro having the biggest impact. These movements have influenced both the reported income statement and the cash flow and closing net cash position, (as set out in note 2 and the cash flow statement in the financial statements), in the following ways: 1. Income statement - the most important impact was the end of year mark to market of outstanding financial instruments (foreign exchange contracts, interest rate, commodity and jet fuel swaps). The principal adjustments related to the GBP/USD hedge book. The principal movements in 2008 were as follows: Open Close ____________________ __________ __________ GBP - USD Â£1 - $ 1.991 Â£1 - $ 1.438 GBP - EUR Â£1 - â‚¬ 1.362 Â£1 - â‚¬ 1.034 Oil - Spot Brent $93/bbl $49/bbl ____________________ __________ __________ The impact of this mark to market is included in net financing in the income statement and caused a net Â£2.5 billion cost, contributing to a published loss before tax of Â£1,892 million. These adjustments are non-cash, accounting adjustments required under IAS39 Financial Instruments: Recognition and Measurement. As a result, reported earnings do not reflect the economic substance of derivatives that have been settled in the financial year, but do include the unrealised gains and losses on derivatives that will only affect cash flows when they are settled at some point in the future to match trading cash flows. Underlying earnings are presented on a basis that shows the economic substance of the Group's hedging strategies in respect of transactional exchange rates and commodity price movements. Further details and information are included within the section on key performance indicators on page15 and in notes 2 and 5 of the financial statements. The achieved rate on selling net US dollar income will be similar in 2009 to that in 2008 and will gradually improve thereafter as the Group is able to absorb the lower value of sterling in its hedge books into the achieved rate. The revaluation costs, which are measured at a point in time, do not, therefore, represent additional currency headwinds. The improving average rate in the hedge book will lead to improving achieved rates over time. 2. Cash flow and balance sheet - the Group maintains a number of currency cash balances which vary throughout the financial year. Given the significant movements in foreign exchange rates in 2008, a number of these cash balances were inflated by the effects of retranslation at the year end, causing an increase of Â£439 million in the 2008 cash flow and hence the closing balance sheet cash position. Summary The Group's revenues increased by 22 per cent in 2008 to Â£9,082 million with 84 per cent of revenues from customers outside the UK. - Underlying growth of 11 per cent in civil aerospace revenues was supported by strong growth from original equipment with 987 engines delivered in the year, a 16 per cent increase over 2007, and growth across all sectors - widebody, narrowbody and corporate and regional. Services revenues increased by seven per cent over 2007. - Underlying defence aerospace revenues were similar to 2007 with new equipment revenues down seven per cent and services revenues increasing by eight per cent over 2007. - The marine business continued to grow rapidly in 2008 with underlying revenues increasing 42 per cent from 2007 to Â£2,204 million, driven by strong demand for product and support in the offshore oil and gas sector. Overall new equipment revenues increased by 49 per cent to Â£1,492 million with services revenues increasing 31 per cent to Â£712 million. - The energy business made good progress in the year with underlying revenues up 35 per cent, supported by good growth in both original equipment and services activities. Overall underlying services revenues increased by 11 per cent in 2008 to Â£4,755 million and accounted for 52 per cent of Group revenues for the year. Underlying profit margins before financing costs reduced slightly from 10.6 per cent in 2007 to ten per cent in 2008. The reduction in margin was the result of an increased proportion of original equipment to service revenues, increased unit costs and further headwinds on foreign exchange. These were partially offset by the benefits of increased volumes, improving productivity and cost reduction activity. Underlying financing costs remained relatively stable at Â£ 39 million (2007 Â£32 million) including net interest of Â£10 million and finance costs associated with financial risk and revenue sharing partnerships. Restructuring charges in 2008 increased to Â£82 million (2007 Â£52 million) as the Group continued its focus on operational improvements, including the reduction in the number of people working in support functions. These costs are included within operating costs. A final payment to shareholders of 8.58p per share, in the form of C Shares, is proposed, making a total of 14.30p per share, a ten per cent increase over the 2007 total. Order book The order book at December 31, 2008, at constant exchange rates, was Â£55.5 billion (2007 Â£45.9 billion) with strong growth across all divisions. This included firm business that had been announced but for which contracts had not yet been signed of Â£6.1 billion (2007 Â£7.1 billion). In civil aerospace, it is common for a customer to take options for future orders in addition to firm orders placed. Such options are excluded from the order book. In defence aerospace, long-term programmes are often ordered for only one year at a time. In such circumstances, even though there may be no alternative engine choice available to the customer, only the contracted business is included in the order book. Aftermarket services agreements, including TotalCare packages, represented 26 per cent of the order book, having increased by Â£1.4 billion in the year. These are long-term contracts where only the first seven years' revenue is included in the order book. Aftermarket services The Group continues to be successful in developing its aftermarket services activities. These grew by 11 per cent on an underlying basis in 2008 and accounted for 52 per cent of Group revenue. In particular, TotalCare packages in the civil aerospace sector now cover 57 per cent, by value, of the installed fleet. TotalCare packages cover long-term management of the maintenance and associated logistics for our engines and systems, monitoring the equipment in service to deliver the system availability our customers require with predictable costs. The pricing of such contracts reflects their long-term nature. Revenues and costs are recognised based on the stage of completion of the contract, generally measured by reference to flying hours. The overall net position of assets and liabilities on the balance sheet for TotalCare packages was an asset of Â£848 million (2007 Â£550 million). Cash Cash inflow during the year was Â£570 million (2007 Â£562 million, before the special injection of Â£500 million into the UK pension schemes). Continued growth in underlying profits and good cash conversion were supported by increases in customer deposits and progress payments of Â£400 million and the benefit of Â£439 million from year-end currency revaluations. Working capital increased by Â£38 million during the year with increased inventory of Â£208 million, offset by reduced financial working capital of Â£170 million. Inventory increased in the year to support growth across all businesses and to minimise disruption during the transition to new operational facilities. Some reductions in deposits are expected in 2009. Cash investments of Â£675 million in property, plant and equipment and intangible assets and payments to shareholders of Â£200 million represented the major cash outflows in the period. Tax payments increased in the year to Â£117 million (2007 Â£71 million). As a consequence average net cash was Â£375 million (2007 Â£350 million). The net cash balance at the year end was Â£1,458 million (2007 Â£888 million). Taxation The overall tax credit on the loss before tax was Â£547 million (2007 Â£133 million charge), a rate of 28.9 per cent (2007 18.1 per cent). The tax credit in 2008 mainly reflects the loss caused by the mark to market of outstanding financial instruments at the year end. The tax charge on underlying profit was Â£217 million (2007 Â£193 million) a rate of 24.7 per cent (2007 24.1 per cent). The overall tax credit was increased by Â£25 million in respect of the expected benefit of the UK research and development tax credit. This reduced the underlying tax charge by the same amount. In addition, Â£11 million of provisions for prior years' tax liabilities were written back following settlement of a number of outstanding tax issues. The underlying tax rate is expected to increase to around 26 per cent. The operation of most tax systems, including the availability of specific tax deductions, means that there is often a delay between the Group tax charge and the related tax payments, to the benefit of cash flow. The Group operates internationally and is subject to tax in many differing jurisdictions. As a consequence, the Group is routinely subject to tax audits and examinations which, by their nature, can take a considerable period to conclude. Provision is made for known issues based on management's interpretation of country specific legislation and the likely outcome of negotiation or litigation. The Group believes that it has a duty to shareholders to seek to minimise its tax burden but to do so in a manner which is consistent with its commercial objectives and meets its legal obligations and ethical standards. While every effort is made to maximise the tax efficiency of its business transactions, the Group does not use artificial structures in its tax planning. The Group has regard for the intention of the legislation concerned rather than just the wording itself. The Group is committed to building open relationships with tax authorities and to following a policy of full disclosure in order to effect the timely settlement of its tax affairs and to remove uncertainty in its business transactions. Where appropriate, the Group enters into consultation with tax authorities to help shape proposed legislation and future tax policy. Transactions between Rolls-Royce subsidiaries and associates in different jurisdictions are conducted on an arms-length basis and priced as if the transactions were between unrelated entities, in compliance with the OECD Model Tax Convention and the laws of the relevant jurisdictions. Before entering into a transaction the Group makes every effort to determine the tax effect of that transaction with as much certainty as possible. To the extent that advance rulings and clearances are available from tax authorities, in areas of uncertainty, the Group will seek to obtain them and adhere to their terms. Pensions The charges for pensions are calculated in accordance with the requirements of IAS 19 Employee Benefits. The decision by the trustees of each of the principal UK defined benefit schemes, in consultation with the Group, to adopt a lower risk investment strategy during 2007 has served its members and the Group well during 2008. The combination of: i) reducing the overall UK pensions asset allocation to equities from approximately 80 per cent to 20 per cent; ii) hedging the majority of interest rate and inflation risks associated with the pension liabilities, using swap contracts backed by short-term money market assets; and iii) an incremental Â£500 million cash contribution from the Group to the main UK defined benefit schemes in 2007, has significantly reduced volatility and losses as equity prices and interest rates have fallen. Reducing the volatility of the pension schemes is the primary objective of the revised investment strategy to enable the trustees and the Group to plan a schedule of more stable contributions with greater confidence of the schemes being fully funded in the future. Further information and details of the pensions' charge and the defined benefit schemes' assets and liabilities are shown in note 18 to the financial statements. The net deficit, after taking account of deferred tax, was Â£93 million (2007 Â£88 million). Changes in this net position are affected by the assumptions made in valuing the liabilities and the market performance of the assets. Investments The Group continues to subject all investments to rigorous examination of risks and future cash flows to ensure that they create shareholder value. All major investments require Board approval. The Group has a portfolio of projects at different stages of their life cycles. Discounted cash flow analysis of the remaining life of projects is performed on a regular basis. Sales of engines in production are assessed against criteria in the original development programme to ensure that overall value is enhanced. Gross research and development investment amounted to Â£885 million (2007 Â£824 million). Net research and development charged to the income statement was Â£403 million (2007 Â£381 million). The level of self-funded investment in research and development is expected to remain at approximately five per cent of Group sales in the future. The impact of this investment on the income statement will reflect the mix and maturity of individual development programmes and will result in a similar level of net research and development charged within the income statement in 2009. The continued development and replacement of operational facilities contributed to the total investment in property, plant and equipment of Â£283 million (2007 Â£304 million). Investment in 2009 is anticipated to be slightly reduced from the 2008 level as the investments in new facilities in the US and Singapore are rephased to reflect the timing of major new airframe programmes. Investment in training was Â£30 million (2007 Â£30 million). Intangible assets The Group carried forward Â£2,286 million (2007 Â£1,761 million) of intangible assets. This comprised purchased goodwill of Â£1,008 million, engine certification costs and participation fees of Â£403 million, development expenditure of Â£456 million, recoverable engine costs of Â£213 million and other intangible assets of Â£206 million. Expenditure on intangible assets is expected to increase modestly in 2009. Partnerships The development of effective partnerships continues to be a key feature of the Group's long-term strategy. Major partnerships are of two types: joint ventures and risk and revenue sharing partnerships. Joint ventures Joint ventures are an integral part of our business. They are involved in engineering, manufacturing, repair and overhaul, and financial services. They are also common business structures for companies participating in international, collaborative defence projects. They share risk and investment, bring expertise and access to markets, and provide external objectivity. Some of our joint ventures have become substantial businesses. A major proportion of the debt of the joint ventures is secured on the assets of the respective companies and is non-recourse to the Group. Risk and revenue sharing partnerships (RRSPs) RRSPs have enabled the Group to build a broad portfolio of engines, thereby reducing the exposure of the business to individual product risk. The primary financial benefit is a reduction of the burden of research and development (R& D) expenditure on new programmes. The related R&D expenditure is expensed through the income statement and the initial programme receipts from partners, which reimburse the Group for past R& D expenditure, are also recorded in the income statement, as other operating income. RRSP agreements are a standard form of co-operation in the civil aero-engine industry. They bring benefits to the engine manufacturer and the partner. Specifically, for the engine manufacturer they bring some or all of the following benefits: additional financial and engineering resource; sharing of risk; and initial programme contribution. As appropriate, the partner also supplies components and as consideration for these components, receives a share of the long-term revenues generated by the engine programme in proportion to its purchased programme share. The sharing of risk is fundamental to RRSP agreements. Partners share financial investment in the programme, in general they share: - market risk as they receive their return from future sales; - currency risk as their returns are denominated in US dollars; - sales financing obligations; - warranty costs; and - where they are manufacturing or development partners, technical and cost risk. Partners that do not undertake development work or supply components are referred to as financial RRSPs and are accounted for as financial instruments as described in the accounting policies on page 91. In 2008, the Group received other operating income of Â£79 million (2007 Â£50 million). Payments to RRSPs are recorded within cost of sales and increase as the related programme sales increase. These payments amounted to Â£268 million (2007 Â£199 million). The classification of financial RRSPs as financial instruments has resulted in a liability of Â£455 million (2007 Â£315 million) being recorded in the balance sheet and an associated underlying financing cost of Â£26 million (2007 Â£26 million) recorded in the income statement. In the past, the Group has also received government launch investment in respect of certain programmes. The treatment of this investment is similar to non-financial RRSPs. Risk management The Board has an established, structured approach to risk management. The risk committee (see page 69) has accountability for the system of risk management and reporting the key risks and associated mitigating actions. The Director of Risk reports to the Finance Director. The Group's policy is to preserve the resources upon which its continuing reputation, viability and profitability are built, to enable the corporate objectives to be achieved through the operation of the Rolls-Royce business processes. Risks are formally identified and recorded in a corporate risk register and its subsidiary registers within the businesses, which are reviewed and updated on a regular basis, with risk mitigation plans identified for significant risks. Financial risk The Group uses various financial instruments in order to manage the exposures that arise from its business operations as a result of movements in financial markets. All treasury activities are focused on the management and hedging of risk. It is the Group's policy not to trade financial instruments or to engage in speculative financial transactions. There have been no significant changes in the Group's policies in the last year. The principal economic and market risks continue to be movements in foreign currency exchange rates, interest rates and commodity prices. The Board regularly reviews the Group's exposures and financial risk management and a specialist committee also considers these in detail. All such exposures are managed by the Group Treasury function, which reports to the Finance Director and which operates within written policies approved by the Board and within the internal control framework described on page 80. Counterparty credit risk The Group has an established policy for managing counterparty credit risk. A common framework exists to measure, report and control exposures to counterparties across the Group using value-at-risk and fair-value techniques. The Group assigns an internal credit rating to each counterparty, which is assessed with reference to publicly available credit information, such as that provided by Moody's, Standard & Poor's, and other recognised market sources, and is reviewed regularly. Financial instruments are only transacted with counterparties that have a publicly assigned long-term credit rating from Standard & Poor's of `A-' or better and from Moody's of `AFF' or better. Funding and liquidity The Group finances its operations through a mixture of shareholders' funds, bank borrowings, bonds, notes and finance leases. The Group borrows in the major global markets in a range of currencies and employs derivatives where appropriate to generate the desired currency and interest rate profile. The Group's objective is to hold financial investments and maintain undrawn committed facilities at a level sufficient to ensure that the Group has available funds to meet its medium-term capital and funding obligations and to meet any unforeseen obligations and opportunities. The Group holds cash and short-term investments which, together with the undrawn committed facilities, enable it to manage its liquidity risk. Short-term investments are generally held as bank deposits or in `AAA' rated money market funds. The Group operates a conservative investment policy which limits investments to high quality instruments with a short-term credit rating of `A-1' from Standard & Poor's or better and `P-1' from Moody's. Counterparty diversification is achieved with suitable risk-adjusted concentration limits. Investment decisions are refined through a system of monitoring real-time equity and credit-default swap (CDS) price movements of potential investment counterparties which are compared to other relevant benchmark indices and then risk-weighted accordingly. During 2008, the Group did not experience any capital losses relating to its investments as a result of the credit crisis. The Group increased its borrowing facilities during 2008 with the addition of a new Â£200 million loan facility from the European Investment Bank (EIB) relating to research and development. As at December 31, 2008 the Group had total committed borrowing facilities of Â£1.7 billion (2007 Â£1.5 billion). There are no material debt facility maturities until 2011. The maturity profile of the borrowing facilities is staggered to ensure that refinancing levels are manageable in the context of the business and market conditions. There are no rating triggers contained in any of the Group's facilities that could require the Group to accelerate or repay any facility for a given movement in the Group's credit rating. The Group's Â£250 million bank revolving credit facility contains a rating price grid, which determines the borrowing margin for a given credit rating. The Group's current borrowing margin would be 20 basic points (bp) over sterling LIBOR if drawn. The borrowing margin on this facility increases by approximately 5bp per one notch rating downgrade, up to a maximum borrowing margin of 55bp. The facility was not drawn during 2008. There are no rating price grids contained in the Group's other borrowing facilities. The Group continues to have access to all the major global debt markets. Credit rating The Group subscribes to both Moody's Investors Service and Standard & Poor's for its official publicised credit ratings. As at December 31, 2008 the Group's assigned long-term credit ratings were: Rating agency Rating Outlook Category ______________ ______ _______ ___________ Moody's A3 Stable Investment grade ______________ ______ _______ ___________ Standard A- Stable Investment & Poor's grade ______________ ______ _______ ___________ As a long-term business, the Group attaches significant importance to maintaining an investment grade credit rating, which it views as necessary for the business to operate effectively. The Group's objective is to maintain an `A' category investment grade credit rating from both agencies. Currency risk The Group is exposed to movements in exchange rates for both foreign currency transactions and the translation of net assets and income statements of foreign subsidiaries. The Group regards its interests in overseas subsidiary companies as long-term investments and manages its translational exposures through the currency matching of assets and liabilities where applicable. The matching is reviewed regularly, with appropriate risk mitigation performed where material mismatches arise. The Group is exposed to a number of foreign currencies. The most significant transactional currency exposures are US dollars to sterling and US dollars to euros. The Group manages its exposure to movements in exchange rates at two levels: i) Revenues and costs are currency matched where it is economic to do so. The Group actively seeks to source suppliers with the relevant currency cost base to avoid the risk or to flow down the risk to those suppliers that are capable of managing it. Currency risk is also a prime consideration when deciding where to locate new facilities. US dollar income converted into sterling represented 26 per cent of Group revenues in 2008 (2007 25 per cent). US dollar income converted into euros represented four per cent of Group revenues in 2008 (2007 four per cent). ii) Residual currency exposure is hedged via the financial markets. The Group operates a hedging policy using a variety of financial instruments with the objective of minimising the impact of fluctuations in exchange rates on future transactions and cash flows. Market exchange rates 2008 2007 ___________________________ _____ _____ USD per GBP ___________________________ _____ _____ - Year-end spot rate 1.438 1.991 ___________________________ _____ _____ - Average spot rate 1.854 2.001 ___________________________ _____ _____ EUR per GBP ___________________________ _____ _____ - Year-end spot rate 1.034 1.362 ___________________________ _____ _____ - Average spot rate 1.258 1.461 ___________________________ _____ _____ The permitted range of the amount of cover taken is determined by the written policies set by the Board, based on known and forecast income levels. The forward cover is managed within the parameters of these policies in order to achieve the Group's objectives, having regard to the Group's view of long-term exchange rates. Forward cover is in the form of standard foreign exchange contracts and instruments on which the exchange rates achieved are dependent on future interest rates. The Group may also write currency options against a portion of the unhedged dollar income at a rate which is consistent with the Group's long-term target rate. At the end of 2008 the Group had US$17.1 billion of forward cover (2007 US$9.4 billion). The consequence of this policy has been to maintain relatively stable long-term foreign exchange rates. Note 16 to the financial statements includes the impact of revaluing forward currency contracts at market values on December 31, 2008, showing a negative value of Â£2,181 million (2007 positive value of Â£379 million) which will fluctuate with exchange rates over time. The Group has entered into these forward contracts as part of the hedging policy, described above, in order to mitigate the impact of volatile exchange rates. Interest rate risk The Group uses fixed rate bonds and floating rate debt as funding sources. The Group's policy is to maintain a proportion of its debt at fixed rates of interest having regard to the prevailing interest rate outlook. To implement this policy the Group may utilise a combination of interest-rate swaps, forward-rate agreements and interest-rate caps to manage the exposure. Commodity risk The Group has an ongoing exposure to the price of jet fuel and base metals arising from business operations. The Group's objective is to minimise the impact of price fluctuations. The exposure is hedged, on a similar basis to that adopted for currency risks, in accordance with parameters contained in written policies set by the Board. Sales financing In connection with the sale of its products, the Group will, on some occasions, provide financing support for its customers. This may involve the Group guaranteeing financing for customers, providing asset-value guarantees (AVGs) on aircraft for a proportion of their expected future value, or entering into leasing transactions. The Group manages and monitors its sales finance related exposures to customers and products within written policies approved by the Board and within the internal framework described in the corporate governance section. The contingent liabilities represent the maximum discounted aggregate gross and net exposure that the Group has in respect of delivered aircraft, regardless of the point in time at which such exposures may arise. The Group uses Ascend Worldwide Limited as an independent appraiser to value its security portfolio at both the half year and year end. Ascend provides specific values (both current and forecast future values) for each asset in the security portfolio. These values are then used to assess the Group's net exposure. The permitted levels of gross and net exposure are limited in aggregate, by counterparty, by product type and by calendar year. The Group's gross exposures were divided approximately 55:45 between AVGs and credit guarantees in 2008 (2007 55:45). They are spread over many years and relate to a number of customers and a broad product portfolio. The Board regularly reviews the Group's sales finance related exposures and risk management activities. Each financing commitment is subject to a credit and asset review process and prior approval in accordance with Board delegations of authority. The Group operates a sophisticated risk-pricing model to assess risk and exposure. Costs and exposures associated with providing financing support are incorporated in any decision to secure new business. The Group seeks to minimise the level of exposure from sales finance commitments by: - the use of third-party non-recourse debt where appropriate; - the transfer, sale, or reinsurance of risks; and - ensuring the proportionate flow down of risk and exposure to relevant RRSPs. Each of the above forms an active part of the Group's exposure management process. Where exposures arise, the strategy has been, and continues to be, to assume where possible liquid forms of financing commitment that may be sold or transferred to third parties when the opportunity arises. Note 23 to the financial statements describes the Group's contingent liabilities. There were no material changes to the Group's gross and net contingent liabilities during 2008. Accounting standards The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS), as adopted by the EU. No standards or interpretations that become effective during 2008 had a significant impact on the Group's financial statements. A summary of other changes, which have not been adopted in 2008, is included within the accounting policies in note 1 to the financial statements. Share price During the year the Company's share price decreased by 39 per cent from 546p to 335.5p, compared to a 28 per cent decrease in the aerospace and defence sector and a 31 per cent decrease in the FTSE100. The Company's shares ranged in price from 547p in January to 249p in October. The number of ordinary shares in issue at the end of the year was 1,844 million, an increase of 24 million of which 12 million related to share options and 12 million related to conversion of B Shares into ordinary shares. The average number of ordinary shares in issue was 1,820 million (2007 1,800 million). Andrew Shilston Finance Director February 11, 2009 Note: Related party transactions Significant transactions in the financial year were as follows: 2008 2007 Â£m Â£m ___________________________________________ _____ _____ Sale of goods and services to joint ventures 1,555 1,289 Purchases of goods and services from joint (1,482 ) (1,100 ) ventures ___________________________________________ _____ _____

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