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Strategic ReportChairman’s StatementRolls-Royce Holdings plc Annual Report 2018I would like to highlight the exceptionalperformance of Power Systems. The businesshas made the most of strong end markets,but additionally has made some innovativebreakthroughs in services and newtechnologies such as hybrid power for trains.We are also seeing tangible examples oftechnology transfer between Power Systemsand our other businesses, particularly inaftermarket services, a crucial componentof the Rolls-Royce business model.We have had setbacks, however, the mostsignificant of which has been operationalissues with our in-service fleet, particularlywith our Trent 1000 engine. This has causedpain for us and even more importantly formany of our customers. In the end, businessesare there for their customers and we verymuch regret the disruption caused. Thishas been an area of continuing focus andoversight by the Board. That said, I wouldlike to draw attention to the heroic effortsof our engineering and customer supportteams (and indeed to those of our partnercustomers) in addressing the issues, whilemaintaining their absolute dedication toensuring product safety – our mostimportant priority.At the time of writing we do not have clarityon the UK’s withdrawal from the EuropeanUnion. During 2018 we took steps to preparefor different potential outcomes with aparticular focus on supply chain continuityand retaining essential capabilities. Thepotential risks and impacts considered byour Brexit steering group is included in thePrincipal Risks section in this report (seepage 50) and the risks relating to Brexitwere also included in our viabilityassessment (see page 55).We specified our targets and ambitions forcash flow – our priority near-term financialobjective – but also introduced a newmeasure: cash return on invested capital(CROIC). This will be a primary long-termfinancial measure and the basis for capitalallocation decisions.It is proposed that the final payment for 2018is unchanged from 2017 at 7.1 pence pershare. Taken together with the interimpayment, this brings the full-year paymentto 11.7 pence per share. As with pastpayments, the distribution will be in theform of C Shares.We have continued also to focus on engagingwith our employees. I talk more about thisin the Corporate Governance section (seepage 67). Irene Dorner has been designatedas Employee Champion on the Board andshe has geographic support in this rolefrom Beverly Goulet in North America. AllDirectors are encouraged, and expected,to visit our operations across the world andto engage with employees on these trips atopen invitation Meet the Board events. Thishelps us to understand the culture of theCompany as well as to hear employees’concerns and exciting ideas directly.Such visits also help us observe progresson key topics such as diversity and safetyawareness. At the same time, it helpsdemystify the Board and, hopefully,makes us more human and accessible.Our performance has improved significantlyfrom the position in which we foundourselves three years ago and it remainsour stated objective, in the long term,to progressively rebuild payments toshareholders to an appropriate level,subject to the cash needs of the business.This reflects the Board’s long-standingconfidence in the strong cash generationpotential of Rolls-Royce, as we build ourshare of the widebody engine market andbenefit from the consequent increase inservices revenue.We continue to engage actively withgovernments and social organisations tounderstand our broader impact on issuessuch as the environment.We have always pursued the goal of cleaner,safer and more competitive power, and werecognise our role and responsibility inenabling the transition to a low carbonworld. We understand our obligations andare keen to partner and collaborate to findsolutions while delivering on our corebusiness purpose.“Strategically wehave sustained ourinvestments in thetechnologies that willensure our long-termcompetitiveness andinnovation ambitions.”Stakeholder trust and confidenceBuilding credibility and trust withstakeholders is a priority. We held anotherCapital Markets event with our investorsin 2018, at which we clarified our financialmetrics and performance and provideda detailed review of our Power Systemsbusiness and of the organisational andcultural changes we are planning.Shareholder paymentsAlthough we are emerging from a verysignificant investment cycle, the needsof the business are substantial. Steps havebeen taken in 2018 to further strengthenthe balance sheet. However, it is sustainablefree cash flow from within our businessupon which we must base our shareholderpayment strategy and we still have work todo in order to deliver that.Board developmentsDuring the year we announced theappointment of Nick Luff as a Non-ExecutiveDirector. He joined the Board followingthe AGM and is a member of the AuditCommittee and Safety & Ethics Committeeas well as the Nominations & GovernanceCommittee. A chartered accountant andchief financial officer of RELX Group, hebrings to your Board additional financialand accounting acumen. He also hasexpertise and experience in cyber securityand is active in the oversight of this keyactivity – and risk – for the Group.Looking forwardOur medium-term prospects remain brightand the long-term growth opportunitiesare significant. Our immediate focus ison improved financial and operationalperformance so that we have a sound andcredible financial platform for productivelong-term investment into rapidly growingmarkets. Our technology platforms – in gasturbines, in micro-grids and in electricalpropulsion – will be fundamental to this.We have further work to do on restructuringand on improving our internal processesand controls, and shifting the cultureremains an important priority as Warrentalks about in his statement.I would like to conclude by thanking all mycolleagues and co-workers at Rolls-Roycefor their dedication and hard work inchallenging circumstances. Their pridein the Company, and the determinationto improve and develop, are one of ourgreatest assets.Ian DavisChairmanSTRATEGIC REPORTThe successful development and adoptionof digital technologies across the wholeof our Group will be fundamental to bothimproved cost efficiency and quality, andalso to our long-term growth platforms.I am particularly excited about some of ourachievements in this area – for example theestablishment of R² Data Labs and creationof a digital ecosystem through partnershipswith start-ups and academia.05

06Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 2018CHIEF EXECUTIVE’S REVIEWOur goal was to make 2018 a breakthrough year for Rolls-Royceand real progress has been made in realising that ambition. We areseeing the crucial behavioural changes we need to build momentumand sustain these positive changes.Progress in 2018At the start of the year I made clear that ourgoal was to make 2018 a breakthrough yearfor Rolls-Royce and real progress has beenmade in realising that ambition. We havetaken significant strategic steps, with thesimplification of our Group and subsequentlaunch of a more fundamental restructuringpositioning us for success. We are nowstarting to see the crucial cultural andbehavioural breakthrough Rolls-Roycerequires to build real momentum andsustain the positive change seen in 2018for the long term, in support of ouraspiration to be the world’s leadingindustrial technology company.Underlying financial results were aheadof expectations with strong growth fromCivil Aerospace and Power Systems anda steady performance in Defence andITP Aero. We reported good growth inunderlying revenues and delivered amaterial improvement in underlying profitand free cash flow – another step along thejourney towards free cash flow of at least 1bn by 2020. During the year we extendedthat financial horizon, with a mid-termambition for free cash flow per share toexceed 1, in line with our ongoing driveto increase openness and transparencywith investors. The message is clear: aftera decade of significant investment we arecommitted to delivering improved returnswhile continuing to invest in the innovationneeded to realise our long-term aspiration.While we achieved a number of importantoperational and technical milestones duringthe year, we faced the challenge ofin-service issues with the Trent 1000 whichcaused significant disruption for a numberof our customers, which we sincerely regret.Given the advanced nature of theengineering requirements of aerospaceproducts, such in-service issues can occurin our industry and it is the behaviour of ourCompany in dealing with them which will beWARREN EASTCHIEF EXECUTIVE

Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 2018Our colleagues in Civil Aerospace haveworked tirelessly to minimise disruption:designing new parts and inspectiontechniques and gaining the necessaryregulatory approvals; increasing blademanufacturing; and growing maintenancecapacity. I have been particularly encouragedby the attitude of the wider business to thischallenge. Everyone has rallied round andtaken the necessary mitigating actions inorder to accommodate the additional coststhat we incurred during the year. As a wholeorganisation we responded and delivered,and that is a real breakthrough.Consistent with the announcement fromAirbus in early 2019 that A380 deliverieswill end in 2021, we will deliver our finaltranche of Trent 900 engines over the nexttwo years. The financial impact of this hasbeen reflected as an exceptional item.We look forward to maintaining the in-serviceTrent 900 fleet for many years to come.Strategic and cultural changeWe entered the year with a clear, refreshedvision to pioneer cutting-edge technologiesthat deliver clean, safe and competitivesolutions to meet our planet’s vital powerneeds (see page 10). Following that vision,the year began with the further simplificationof the Group from five operating businessesto three core units – Civil Aerospace, PowerSystems and Defence – enabling us to actwith much greater pace in meeting the needsof our customers. Creating a Defenceoperation with increased scale, for instance,will present us with further opportunitiesin the future. ITP Aero, acquired in 2017,remains a separate business unit withinthe Group.We also took the decision to carry out astrategic review of our Commercial Marineoperations, resulting in the sale of thebusiness, due to complete in the first halfof 2019. The team in Marine has respondedadmirably to a significant downturn in theoffshore oil & gas market to reduce its costbase, while simultaneously carving out anindustry-leading position in ship intelligenceand autonomous shipping. We believe,however, that its future will be better servedunder new ownership. This business hasbeen reclassified within assets held for sale.During the year we sold L’Orange, whichsupplies fuel injection technology; enablingPower Systems to focus on other long-term,high-growth opportunities and the Groupto allocate our capital to core technologies.These strategic changes enabled us toembark upon a 24-month programme offundamental restructuring, to create smallerand more cost-effective corporate andsupport functions and reduce managementlayers and complexity (see page 08). Weexpect the proposed restructuring will leadto the reduction of around 4,600 rolesby mid-2020. By the end of the year ournon-manufacturing headcount had reducedby around 1,300. It is never an easy decisionto reduce our workforce, but we mustfundamentally change the way we work.We are replacing a heavily-centralisedcontrol culture with empowered businesses,operating within a framework, in a leanerstructure with much clearer accountabilities.We have reduced the size of our head officeto focus solely on corporate governance,strategy and ensuring that we fulfil ourcorporate responsibilities as a publiclylisted company. From the start of this year,our businesses are being supported by aGroup Business Services (GBS)organisation, which pools our professionaland transactional services; and anInnovation Hub, which draws togetherskillsets and expertise which have commonapplication across the Group includingdigital capabilities, future technologies andstrategic insight. This activity will foster2018 prioritiesCustomersTechnologyResilienceFinancial progressmitigate impact torectify in-serviceissues, ramp uplarge engineproduction,grow servicecapabilitiesfocus throughproductdigitalisation,electrificationand revitalisationthroughadaptability witha spotlight onsafety, diversity &inclusion, and thehighest ethicalstandardsdeliveringimproving freecash flow,strengtheningbalance sheet,more disciplinedcapital allocationquicker decision-making but must beaccompanied by the appropriate behaviouralchange; only then will this breakthroughbe sustained into the long term.The move to more empowered businessesremoved the requirement for a Group ChiefOperating Officer role and the ExecutiveTeam is now firmly focused on driving therequired cultural change across the Group.We are embedding the behaviours that weneed from our people through our careframework (see page 44), starting with thenewly created Enterprise Leadership Group(ELG), consisting of the top senior managersfrom across the Group. Formed in 2018, theELG gathered together for the first timeearly in 2019 and their level of energy waspalpable – a clear signal that senior leadersare highly engaged. Crucially, there is afundamental understanding that they are,first and foremost, leaders of the wholeenterprise, not solely of a business orfunction. That enterprise-first mentality isvital to create the collaborative and agileorganisation we need to become the world’sleading industrial technology company.Delivery on 2018 prioritiesAt the beginning of the year, we set outfour key priorities:Priority 1: CustomersOur simplification and restructuring willshift our centre of gravity much closerto our customers and during the year wedelivered on many of our promises to them.We joined Airbus and Qatar Airways tocelebrate the delivery of the firstAirbus A350-1000 to enter service, the firstaircraft to be powered by our Trent XWB-97engines; welcomed the delivery of the firstA350 to mainland China; and saw thehandover of the first A330neo, powered byour Trent 7000, to launch customer TAP AirPortugal. Civil Aerospace deals signedduring the year included Trent XWB engineand long-term TotalCare service agreementswith China Eastern Airlines and TurkishAirlines. During the year, the Trent XWBpassed two important milestones as thefleet recorded two million flying hours justdays after the 500th engine was deliveredto Airbus. The Trent 700 fleet, meanwhile,passed two even greater milestones as thefleet recorded 50 million flying hours andthe 2000th engine delivery. We alsoannounced our first launch customers forLessorCare, designed to meet theaftermarket needs of aircraft lessors, andsubsequently added LifeKey, which givescustomers greater control over their assets.STRATEGIC REPORTremembered by customers. We arerecognising a significant exceptionalcharge within our financial figures for2018 as a result of the abnormal cost ofour contribution to dealing with customerdisruption, but we are managing the issuesand good progress was made in the yearon long-term solutions (see page 24).07

08Strategic ReportChief Executive’s ReviewDuring the year, we launched a new enginefamily for business aviation, with theintroduction of the Pearl, and the first engine– the Pearl 15 – will be the sole engine forBombardier’s latest business jets(see page 28).We were selected by the UK Government toplay a pivotal role in Team Tempest, providingpower and propulsion for the new UK combatfighter programme; scored a significantvictory with our first partnership on a majormilitary programme with Boeing Defense,powering the US Navy’s new MQ-25 Stingrayaircraft; and, following a concerted effortover the past few years to get ourperformance back on track, 2018 saw usdeliver on all our promises to the Astute andDreadnought submarine build programmes.We signed memoranda of understandingfor hybrid rail PowerPacks in Germany,Ireland and the UK (see page 31) andincreased the number of long-term serviceagreements with customers of PowerSystems, increasing our opportunities in theaftermarket and further replicating themodel we pioneered in Civil Aerospace.For some of our customers, however, theyear was marred by the in-service issueswith the Trent 1000 (see page 26). Coupledwith challenges within our external supplychain, the increased load placed on our testcapacity by the Trent 1000 issue meantdelays in deliveries of the Trent 7000 at theRolls-Royce Holdings plc Annual Report 2018end of the year. Overall we delivered fewerTrent engines during the year than weanticipated, a situation which we have beenworking hard to address in early 2019. Wealso had delivery issues in our Defence andPower Systems businesses.Priority 2: TechnologyDuring the year we made encouragingprogress on existing programmes, newdemonstrators and future technologies.We are making excellent progress on ournew UltraFan demonstrator (see page 41),which is not only the foundation upon whichour future large civil aero engines will bebased but provides underlyingtechnologies that will support other areasof our Group. We made encouragingprogress in our strategy to championelectrification: developing programmesto demonstrate small-scale full-electric andhybrid-electric flight (see page 09) andlaunching our own micro-grids offering(see page 32); and in our strategy toreinvent our business with new digitaltechnologies, R2 Data Labs – our datainnovation team – delivered significantincremental value during the year for usand our customers by using new techniquesand technologies. Our Digital Academytrained hundreds of employees in datainnovation. As evidence of the scale ofprogress made in 2018, we had 892 patentsapproved for filing, a new record, withOUR FUNDAMENTALRESTRUCTURINGA significant step towards making 2018 abreakthrough year came in June with thelaunch of our fundamental restructuring.The 24-month programme will create anorganisation that will better enable us tomaximise the economic value of the verysignificant investments Rolls-Royce hasmade over the past decade; realise thegrowth potential embedded in ourbusiness; and seize the opportunities wesee across all our markets.We are addressing four areas: structure,culture, processes and people. They arehighly interconnected and it is only bysimultaneously attacking all four that wecan bring about lasting change. This meanslooking at both reducing activity andenhancing capability.The restructuring will create a simpler,healthier and more dynamic organisationwith clearer accountabilities, greaterproductivity and quicker decision-making.two-thirds related to new technologiesfor UltraFan, electrical and digital.Priority 3: ResilienceDuring the year, we established andintroduced a new simple leadershipframework of behaviours and values andthis will be used as a performance measurefor managers this year. We successfullyrolled out our new Zero Harm programmeand accompanying Life Saving Rules, andcontinued to make progress on our healthand safety medium-term goals, thoughunfortunately our progress has been slowerthan we would have liked.We continue to make progress towardsour 2020 diversity targets during the year,actively recruiting from groups typicallyunder-represented in our sector, particularlywomen (see page 46). As part of ourrestructuring and simplification work, wehave made a good start on the simplificationof our management system, removingthousands of spreadsheets and reducingprocesses although much remains to bedone in 2019 to simplify how we work.Priority 4: Financial progressOur underlying results for 2018 were aheadof expectations (see page 18), as webenefited from increased engine flyinghours and higher volumes of shop visits inCivil Aerospace; growth across most of ourStructurePeopleCultureProcessesCreating empowered businesses, operatingwithin a clear framework and supported bya Group Business Services organisation, willlead to a reduction in our indirect workforce.The restructuring is being led throughworkstreams sponsored and owned byExecutive Team members. We havechallenged inefficiencies: for instance,we explored over 18,000 different jobtypes, identifying over 2,000 activities thatwe can stop or significantly change. We arereducing the number of layers in theorganisation and increasing the spans – thenumber of direct reports held by managers– closer to best practice.

Strategic ReportChief Executive’s ReviewRolls-Royce Holdings plc Annual Report 20182019 priorities andlonger-term outlookWe have established a firm foundation in2018 on which to build the success ofRolls-Royce for the longer term. In thecoming year, we will continue to focus onmeeting our commitments to customers,especially in terms of fixing the currentin-service issues and achieving ourdelivery targets.We must continue to invest in thetechnologies that we need, not only tofurther improve our current products,but position ourselves for future growth.We must further increase diversity withinour business and continue the trajectorywe have established over the past few yearsto create real momentum behind thebehavioural changes that we began in 2018.Too often, our business has looked on costreduction measures as a short-term fix andBuilding beyond the breakthrough in 20192019 prioritiesCustomersTechnologyPeople & cultureFinancial–– Increaseproductionvolume–– Expand servicenetwork–– Mitigatedisruptionfrom in-serviceissues–– Revitaliseservice–– Develop newenginearchitecture–– Advanceelectrificationprojects–– Build aresilientbusiness–– Continuerestructuringprogramme–– Further simplifyprocesses–– Diversity &inclusion–– Continueimprovingfree cash flow–– Furtherstrengthenbalance sheet–– Enhancecapitalallocationdisciplinecosts have crept back into the business.We must not allow that to happen again sothat we can take a further significant steptowards our

through-life support solutions for its customers. Underlying revenue 7,378m Underlying operating loss (162)m Underlying revenue mix Reionl Lare Enines 68% V2500 1% 4% Business Aviation 15% See page 24 Defence Defence is a market leader in aero engines for military transport and patrol aircraft with strong positions in combat and helicopter .