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Strategic ReportChairman’s StatementRolls-Royce Holdings plc Annual Report 2019Despite progress on our restructuring andtransformation programme, there remains a lotmore to be done to reduce the cost baseof the business, to simplify our processesand to provide a more agile culture. Thisis a competitive and investor necessity.It is essential to generate the cash flow,shareholder returns and investment fundsrequired for the long-term health of thebusiness. It is also a huge opportunity, andconsistent with our long-term aspirationto be the world leading industrialtechnology company.At the time of writing, there are macro risksto navigate in the coming year, notably theoutbreak of the COVID-19 virus which iscurrently having an effect on world trade,travel, and supply chains. We are activelymonitoring the situation, followinginternational health advice and giving ourpeople as much support as they need.Purpose, strategy and governancePurpose has been, and always will be,fundamental to any company withlong-term aspirations or enduring ambition.We have spent significant time refiningour purpose to ensure it is relevant to ourstakeholders, not least our employees.At its core, our purpose is to connect, powerand protect society. We will do this whileminimising our impact on the environment.Purpose manifests itself in strategy andbehaviour. I hope this report will clarify ourstrategic intent and the actions we are takingto make our purpose real, and measurable,to all our stakeholders. Technology andcapital allocation will be at its heart. Wehave to be at the forefront of technologiessuch as electrification, hybrid propulsionsystems and microgrids that can dramaticallyreduce emissions. Long haul aviation istechnologically challenging from a carbonemissions perspective. Improved engineefficiency will continue to play a veryimportant role in emissions reductionas will alternative non-fossil fuels.We are committed to reducing greenhousegas emissions from our operations andfacilities to zero by 2030. Beyond that, weare working hard to determine how we canmitigate the emissions impact of our productportfolio and product testing in order toget the whole of Rolls-Royce to a net zeroemissions position by 2050. Large scaleaviation is a potentially very challengingsector and to achieve this, we will have tocontinue to work in partnership withgovernments, suppliers, customers,technology providers, fuel companies,non-governmental organisations (NGOs)and civil society. We cannot do it alone.Climate change is a risk to our business –indeed a principal risk – but moreimportantly, it is a real opportunity whichcould see us create disruptive newtechnologies and solutions.We have continued to develop thegovernance innovations highlighted inprevious reports. Irene Dorner, our EmployeeChampion on the Board, continued hersterling efforts during the year, whileBeverly Goulet visited a number of oursmaller sites as our North AmericanEmployee Champion and Lee Hsien Yangheld a series of town hall meetings withemployees and partners in China. We heldfurther Meet the Board events and continuedour Board apprentice programme. We haveintroduced a new tool to track employeeengagement with increased focus on keytopics such as engagement with our purposeand strategy. Statistically and culturallywe still have a way to go on diversity,particularly at the most senior levels. Butwe are making good progress elsewherefrom a talent pipeline perspective and Ibelieve we are on the right path.Finally, we continue to focus attention andoversight on ethical compliance and, aboveall, on safety. This is an ongoing challenge,particularly at times of disruption and stress,for all companies in our industries.Shareholder paymentsDuring the year, further steps were takento simplify the portfolio and improve ournet funds position. We completed the saleof our Commercial Marine business andfinalised the transfer of a significant portionof our pension liabilities to Legal & GeneralAssurance Society. This move will increaseoverall security for Rolls-Royce pensionersand reduce risk to our business.Strengthening the balance sheetunderstandably remains a priority. Thecosts associated with the Trent 1000 haveimpacted investor confidence. Our firmintent is to turn this around. While we havemade progress in delivering the sustainablefree cash flow from our business that wouldbe the foundation for increased shareholderpayments, there is more to be done. As aconsequence, we are not proposing anincrease in the final shareholder paymentfor 2019. This will be held flat at 7.1p pershare. Taken together with the interimpayment, this brings the full payment to 11.7pper share. Despite the challenges of 2019,our underlying financial performance hasshown improvement over the last few years.It remains our objective to progressivelyrebuild distributions to shareholders whileinvesting for the long-term.Board developmentsDuring the year, we announced theappointment of George Culmer as aNon-Executive Director. He joined at thestart of 2020 and is a member of theNominations & Governance Committee,the Audit Committee and the Safety, Ethics& Sustainability Committee. A charteredaccountant, George was until recentlychief financial officer at Lloyds BankingGroup and is also the senior independentdirector at Aviva.We were really sorry to see the departureof Ruth Cairnie as a Non-ExecutiveDirector at the end of the year followingher appointment as chair of BabcockInternational Group. Ruth made extraordinarycontributions to the Board and to theGroup, not least in her role as Chairmanof the Remuneration Committee.Brad Singer, a partner and chief operatingofficer of ValueAct Capital, stepped downas a Non-Executive Director in December.Since joining us in 2016, Brad has been anactive member of the Board, offering avalued external perspective and helping usto drive progress in our efforts to transformRolls-Royce. My colleagues and I havegreatly appreciated Brad’s insight andcommitment to the Company and it hasbeen a pleasure to work alongside him.We have recently announced theappointment of Dame Angela Strank as aNon-Executive Director. She will join theBoard on 1 May 2020 and will be a memberof the Nominations & GovernanceCommittee, the Safety, Ethics & SustainabilityCommittee and the Science & TechnologyCommittee. Dame Angela is currently chiefscientist and head of downstreamtechnology at BP and a member of theirExecutive Management Team. I amdelighted to welcome her to our Board.Looking forwardOur Group continues to operate in marketswhere the long-term trajectory is one ofgrowing demand for power and the servicesthat will support it. To capitalise on theopportunities, however, we must continue tofocus on improving our cost competitiveness;pursue purposeful, disciplined capitalallocation; and drive innovation insustainable, lower carbon power solutions.We must also continue on the culturaltransformation journey that helpsaccelerate our trajectory and attract andretain the talent on which we will depend.Sir Ian DavisChairmanSTRATEGIC REPORTdurability. We have seen signs of progresswith the roll-out of fixes and have a detailedoperational plan to mitigate the disruptionto our customers. As a result of the cost ofthe programme, however, we recognised asignificant exceptional charge in the year.05

06Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 2019CHIEF EXECUTIVE’S REVIEWWARREN EAST, CHIEF EXECUTIVEDespite the challenges of the Trent 1000, the progressseen across the Group in the year gives me increasedconfidence that the changes we are implementing arecreating a tangible and sustainable cultural andperformance shift within our business.Progress in 2019To draw an analogy to describe the yearthat might be familiar to many of ouraerospace customers: the journey issometimes more important than thedestination. In 2019, how we got to ourdestination – strong progress across theGroup – gives me increased confidencethat the changes we have been implementingover the past two years are creating atangible and sustainable cultural andperformance shift within our business.We had a good end to the year includingstrong Civil Aerospace aftermarketperformance, record widebody enginedeliveries, and better trading inPower Systems despite tough marketconditions. Defence performed wellthroughout the year with a record orderintake and healthy cash performance. As aresult, we delivered improved financial resultsincluding a 25% increase in underlyingoperating profit and further strongimprovement in Civil Aerospace. Thiscontributed to strong Group free cash flowof 873m, another significant step towardsachieving at least 1bn in 2020. We alsocontinued to invest in the new technologieswhich are so vital to remaining competitive.This was all achieved despite the in-servicechallenges with the Trent 1000, whichcould have derailed our progress. The factthat they did not is thanks to the focus ofour people on their roles in delivering forthe business.I spoke last year of needing to build beyondthe breakthrough we could see occurringas we launched our restructuring andadopted our new operating structure.We have generated real momentum during2019, not least in respect to costs, as wescrutinised our spending with intense rigourand really challenged ourselves to actdifferently. There is, however, no denyingthe fact that the durability issues with theTrent 1000 weighed heavily on 2019, in termsof the financial cost of returning the fleetto the levels of service our customers expectand dealing with the unacceptable disruptionwe have caused them. As a result of theTrent 1000 and as announced in November,we are recognising a net exceptionalcharge of 1,361m within our financials,contributing to a reported operating lossof (852)m.We have fixes designed for all but one ofthe issues identified and are well advancedon certification and rolling them out intothe fleet. As the year drew to a close, wecarried out a detailed technical re-evaluationof our progress on the final fix, a newhigh pressure turbine blade for theTrent 1000 TEN. Based upon that work andtest activity, we reset our financial andoperational expectations for the engine inNovember, based on a revised estimate offinal blade durability, in order to providecertainty for customers and greater clarityfor investors. Since then, we have madegood progress on the design of this blade,and continue to expect certification of thiscomponent in the first half of 2021.Lower carbon powerWe believe in the positive transformingpotential of technology and have a passionfor solving difficult problems. Today, oneof our society’s greatest technologicalchallenges is the need for lower carbonpower and we have a crucial role to play

Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 2019We set out four key priorities for the year:2019 prioritiesCustomersCustomersPeople and culture–– Increase production volume–– Expand service network–– Mitigate disruption fromin-service issues–– Build a resilient business–– Continue restructuringprogramme–– Further simplify processes–– Diversity & inclusionTechnologyFinancial–– Revitalise service–– Develop new enginearchitecture–– Advance electrificationprojects–– Continue improvingfree cash flow–– Further strengthenbalance sheet–– Enhance capitalallocation disciplinein decarbonising the sectors in which weoperate. Firstly, we are committed to furtherreducing the environmental impacts of ourproducts and services. We are following upour success as the developer of the world’smost efficient civil large engine in servicetoday, the Trent XWB, with our nextgeneration UltraFan. We are also heavilyinvolved in the drive for sustainablealternative fuels. Secondly, we arecommitted to developing new low emissiontechnologies. During 2019, we madesignificant progress, including the acquisitionof Siemens’ eAircraft business and groundtests of our megawatt generator for theE-Fan X demonstrator with Airbus. Thirdly,we are working to reduce the greenhousegas emissions from our own operations andfacilities to zero by 2030.Our ability to pioneer the decarbonisationof aviation builds upon the experience ofour Power Systems business in hybrid andelectrical power across a range of sectors.During the year, we signed customercontracts and framework agreements forhybrid solutions for the rail and yachtmarkets. In early 2020, we further enhancedour capabilities with the acquisition of amajority holding in power storage specialistQinous, which will enhance our microgriddevelopment activities.Climate change is a risk for our businessand playing a pivotal role in combatingit presents us with a very significantopportunity to become a disrupter.Inaction is not an option.Progress on restructuringIn 2019, we made further progress on ourrestructuring programme. Since it wasannounced in mid-2018, we haveimplemented productivity improvementsenabling us to achieve 2,900 of the planned4,600 indirect headcount reduction andwe remain on track to realise the fullbenefits of the programme by the end of2020. Reducing our workforce is not adecision we take lightly, but we mustfundamentally change the way we operate.We have completed the majority of thechanges within Civil Aerospace andDefence, including unwinding an overlycomplex corporate structure andintroducing new automated tools andmethods which have helped streamlineprocesses. Progress within Power Systemswas more limited as we completed plannedstrategic investments. Our Group BusinessServices operation, meanwhile, is nowproviding more effective and efficienttransactional processing across the Group.We have focused on driving value throughreducing other indirect spend beyond salarycosts and on improving the effectivenessof our cash management processes. Thesefoundations will be developed further in2020 to provide additional productivityimprovements in the future.During the year, we delivered a record510 widebody engines from Civil Aerospace,increasing our installed base by 6% to morethan 5,000 engines and growing engineflying hours by 7%. The Trent XWB becameour second-largest Trent programme byvolume, with the fleet having amassed morethan five million flying hours and its leadingengines already achieving our expectationsfor time-on-wing (see page 26). We revampedour Civil Aerospace services business andundertook a record number of scheduledmajor overhauls, in spite of increased checkand repair visits driven by the Trent 1000.During the year, we took the decision toaccelerate the installation of fixes withina small proportion of the Trent 1000 fleetfollowing an incident. As a result, werevised our target to reduce aircraft onground (AOG) to single digits from the endof 2019 to the end of the second quarter of2020. To help alleviate disruption, we tookfurther action to increase our maintenance,repair and overhaul (MRO) capabilities andincreased our pool of spare engines to getour customers flying again.Our Power Systems business continued tocapitalise on its extensive installed base ofengines by increasing revenues from services,including through the introduction of digitalmonitoring tools, initially targeting themining industry.Defence had a very successful year, securinga record order intake of 5.3bn boosted byservices. Notable wins included a five-yearcontract worth over 1bn with theUS Marine Corps to maintain the AE1107engines that power the Bell Boeing V-22Osprey. We delivered just under 500 aeroengines and now have over 16,000 inservice across more than 100 countries.We also made good progress on developingnew technologies ahead of a number ofattractive opportunities in coming years.TechnologyTechnology is the lifeblood of our businessand, during the year, we passed a numberof significant milestones on our new engineprogrammes. We successfully tested all thecomposite elements of our advanced lowpressure system (ALPS) – including fanblades and fan cases – which is a keycomponent of our UltraFan engine design.In Defence, our work as part of TeamTempest in the UK continued. In the US,our dedicated defence development team,LibertyWorks, demonstrated an integratedpower and thermal management system forhigh-power directed energy applicationsSTRATEGIC REPORTDelivery on 2019 priorities07

08Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 2019and we refined our F130 engine for thecompetition to re-engine the US Air Force’s(USAF) Boeing B-52s. Our efforts inelectrification included the introduction ofmicrogrids from Power Systems (see page 30)and breakthroughs in aviation including theroll-out of the all-electric plane we hope willset new speed records (see page 42).People and cultureWe have continued to embed our valuesand behaviours across the Group (seepage 45). Improving diversity & inclusionremains a priority for us and during theyear we refreshed our strategy and lookedto accelerate its implementation. We havea lot of work to do if we are to hit our genderdiversity target of 23% for our ExecutiveTeam. During the year, we reviewed oursuccession plans and increased theproportion of females from 35% to 44%.FinancialFIXING THE TRENT 1000Returning the Trent 1000 fleet to the level of service which our customersexpect is the top priority of senior management and the Board. We believe2019 was a pivotal year. We have now designed fixes for all but one of thesignificant technical challenges we have faced and have a clear pathto resolving the final issue. We have announced actions to boost ourmaintenance capacity and add additional spare engines to reducecustomer disruption. We also carried out an extensive review that resultedin greater certainty for customers and clarity for investors. Our focusis now on executing this clear plan.We have been dealing with three significant technical issues affectingeach of the three variants of the Trent 1000 (Package B, Package C andTEN). Of the nine fixes required, we have so far designed eight and certifiedseven which are now being incorporated into the fleet. A new highpressure turbine (HPT) blade for the Trent 1000 TEN variant is the finalmodification required. During the year, we carried out a detailed technicalre-evaluation of our progress. Based upon that work and test activity, wereset our financial and operational expectations for the Trent 1000 TENbased on a revised estimate of final blade durability. This allowed us to beclearer with customers on the engine’s long-term servicing requirements,giving them greater certainty when planning schedules. It also enabledus to assess the associated exceptional cost and provide investors witha clearer view of future costs (see page 19).The Board continued to scrutinise the issue, receiving regular updates onprogress. The Audit Committee reviewed the accounting treatment ofthe cost (see page 82) and the Board carried out a full technical review(see page 68). To underpin our target to reduce AOG to less than tenby mid-2020, we are increasing our stock of spare engines andaccelerating growth in our MRO network. This comes on top of atripling of MRO capacity over the past three years, the introductionof new servicing techniques and a 50% increase in our turbine blademanufacturing capacity.We delivered significant financial progresswith a strong level of free cash fl

STRTEGC REPORT Rolls-Royce Holdings plc Annual Report 2019 Strategic Report 01 Financial Highlights and Contents Group Financial Highlights Free cash flow 873m 2018: 568m Underlying revenue 15,450m 2018: 15,067m Underlying operating profit 808m 2018: 616m Underlying profit before tax 583m 2018: 466m Underlying earnings per share .