Rolls-Royce Regulatory News (RR.)

28 July 2016

ROLLS-ROYCE HOLDINGS PLC

2016 HALF YEAR RESULTS

Commenting on the results, Warren East, Chief Executive, said: "In the first half of 2016 Rolls-Royce performed broadly in line with expectations, delivering a result a little better than breakeven; and the outlook for the rest of the year remains unchanged. Order intake has been good and, although known headwinds constrained revenue and profit in the first half, the business remains well positioned to deliver a solid second half performance supported by growth in engine deliveries, stronger aftermarket revenues and incremental benefits from our ongoing restructuring programmes."

Underlying: for definition see note 2 on page 32; * translated at constant exchange rates; ** translated at actual exchange rates;

*** free cash flow defined as operating cash after capital expenditure, pensions and taxes, before payments to shareholders, foreign exchange and acquisitions & disposals. The derivation of free cash flow from the cash flow statement is shown on page 44.

H1 highlights

· Reported revenue down 1% at constant exchange rates; reported loss reflects a non-cash impact of £2.2bn period-end mark-to-market revaluation of our derivatives

· Underlying revenue down 5% at constant exchange rates, led by Civil Aerospace and Marine

· Underlying profit before tax at £104m, down 80% at constant exchange rates

· As set out in February 2016, interim payment to shareholders reduced to 4.60 pence per share (2015 interim: 9.27 pence)

Transformation programme

· 2016 programme well underway, good progress on actions to date

· £50m benefit expected in 2016

· Over £100m of annualised savings already identified; on track for £150-200m by end 2017

Looking forward

· Trading outlook for 2016 unchanged

· €720m acquisition of outstanding ITP stake announced 11 July; expected completion early 2017

· Greater clarity on principles of IFRS 15; further work required in order to assess likely impacts

Warren East added: "We have taken some positive first steps on the journey that will lead Rolls-Royce to profitable and highly cash generative growth. Our strategic advantages lie in our focus on engineering excellence, operational excellence and capturing value in the aftermarket. In the first six months, we have made progress with our business transformation; introducing the greater pace and simplicity required to make Rolls-Royce a more resilient company."This announcement has been determined to contain inside information.

Enquiries

Investors:

John Dawson +44 20 7227 9087

Helen Harman +44 20 7227 9339

Ross Hawley +44 20 7227 9282

Media:Richard Wray +44 20 7227 9163

Photographs and broadcast-standard video are available at www.rolls-royce.com.

A PDF copy of this report can be downloaded from www.rolls-royce.com/investors.

This Half Year Results Announcement contains forward-looking statements. Any statements that express forecasts, expectations and projections are not guarantees of future performance and will not be updated. By their nature, these statements involve risk and uncertainty, and a number of factors could cause material differences to the actual results or developments. This report is intended to provide information to shareholders, is not designed to be relied upon by any other party, or for any other purpose and the Company and its directors accept no liability to any other person other than under English law.

Results Presentation

A presentation will be held at 08:45 (GMT) today. Details of how to join the event online are provided below. Downloadable materials will be available on the Rolls-Royce website from the start of the event.

Online webcast registration details for 28 July presentation

To register for the live webcast (including Q&A participation) please visit this link:

http://edge.media-server.com/m/p/u2yh2kw3

Please use this same link to access the webcast replay after the event. 

2016 Half Year Business Highlights

Percentage or absolute change figures in this document are on a constant translational currency ('constant currency') basis unless otherwise stated

* Based on gross revenues prior to intra-group eliminations

Civil Aerospace

· Underlying revenue down 5% and lower gross margins, principally due to:

o Original equipment (OE): increased deliveries of newer Trent engines but lower link-accounted Trent 700 and business aviation sales

o Services: growth from in-production fleet, but declining regional and other large engine fleet aftermarket revenues; increase in technical costs for large engines, including the Trent 1000 but some offsetting foreign exchange benefits

· £3.4bn order book growth; includes over £2bn foreign exchange benefit from long-term US dollar planning rate change

· Good progress on new engine programmes: launch of the Trent XWB-84 EP with Singapore Airlines in February and Trent 1000 TEN receiving EASA certification in early July

· Supply chain modernisation reducing costs and increasing capacity for Trent XWB ramp up

· H2 outlook: increasing deliveries driving OE growth and further targeted lifecycle cost savings on large engine installed base

Defence Aerospace

· Underlying revenue 1% lower; growth in OE revenues offset by reduction in service revenues

· Underlying profit before financing down 33%; reflecting adverse product mix and £31m costs supporting TP400 programme

· Roll-out of further Service Delivery Centres set to enhance aftermarket service offering

· H2 outlook: supported by higher engine deliveries, particularly in transport & patrol; actions underway to mitigate TP400 costs

Power Systems

· Underlying revenue 3% lower; led by weaker OE sales

· Underlying profit before financing 35% lower; reflecting lower volume and changes in mix

· R&D investment focus on higher volume engine applications

· H2 outlook: challenging market environment; healthy closing order book for OE in a number of key market segments; cautious but positive outlook

Marine

· Underlying revenue down 25%; weak offshore markets impacting OE and service revenues

· Underlying profit before financing negative; lower volumes and reduced overhead absorption from weak offshore performance with some offset from non-repeat of contract provision in 2015

· Net restructuring benefits from legacy programmes starting to benefit performance

· H2 outlook: continuing challenging offshore market for OE and services; naval and merchant focus on operational execution and ongoing cost reduction

Nuclear

· Underlying revenue 14% higher; strong revenues led by increased submarine work

· Underlying profit before financing 15% lower, adverse margin mix in submarine projects

· H2 outlook: steady - focus on improving delivery performance

Chief Executive's Review

Introduction

In the first half of 2016, Rolls-Royce performed broadly in line with expectations and the outlook for the rest of the year remains unchanged. Order intake has been good, and although known headwinds constrained revenue and profit in the first half, the business remains well positioned to deliver a solid second half performance supported by growing engine deliveries, underlying growth in aftermarket revenues and incremental benefits from our ongoing restructuring programmes.

Performance in the first six months of 2016

Our performance in H1 2016 was broadly in line with our early expectations, with Trent 700 volume and price reductions, legacy aftermarket reductions and Marine markets causing most of the weakness. At the same time we have continued to invest in products and services to support our customers and reinforce the long-term strength of our order book, valued at £79.5bn including £2.2bn of foreign exchange benefit, up 4% from 2015 year end.

Group underlying revenue reduced 5% on a constant currency basis with reductions in both original equipment and aftermarket services revenues led by the Civil Aerospace and Marine businesses. Previously communicated Trent 700 volume and price reductions, reductions in business jet volumes resulting from softening markets, reduced utilisation and fewer overhauls of some of our more mature widebody large engines and increased technical costs for large engines, including the Trent 1000, were the most significant contributors in Civil Aerospace. This was partly offset by the impact of a change to our long-term US dollar planning rate. Difficult trading conditions in offshore oil and gas markets continue to hamper performance in Marine. Compared to H1 2015, underlying profit before finance charges and tax was 70% lower at £158m.

On an underlying profit before finance charges and tax basis, Civil Aerospace delivered £31m (2015: £248m); Defence Aerospace delivered £128m (2015: £184m); Power Systems delivered £13m (2015: £17m); Marine generated a loss of £(13)m (2015: £4m profit) and Nuclear delivered £18m (2015: £20m excluding the residual Energy business assets now reported in "Other"). More detail on each business is included in the Operational Review.

After underlying financing costs of £54m (2015: £17m including a £24m gain from hedging overseas dividends), underlying profit before tax was £104m (2015: £439m).

Since the EU referendum vote at the end of June, the value of sterling relative to the US dollar fell significantly. As a result, we have recognised a £2.2bn non-cash mark-to-market valuation adjustment for our US dollar hedge book. Reported revenue of £6,462m (2015: £6,370m) was unaffected by this; however the valuation adjustment was the principle reason for reported financing costs being £(2,386)m (2015: £(69)m) and reported loss before tax being £(2,150)m (2015: £310m profit).

After an underlying tax charge of £27m (2015: £102m), underlying profit for the year was £77m (2015: £337m). With an average 1,832m shares in issue, underlying earnings per share were 4.20p (2015: 18.27p).

After a reported tax credit of £378m (2015: £50m), reported loss for the year was £(1,772)m (2015: £360m profit). Reported earnings per share were (96.72)p (2015: 19.51p).

A full reconciliation of underlying to reported profit can be found in note 2 on page 32.

At the same time, the weakness in sterling does present near-term opportunities by providing scope to reduce the average hedge book rate and to benefit from a better conversion of our overseas revenues and costs to marginally enhance our underlying performance. As a result, the weaker pound will enhance underlying full year earnings in future years to the extent our effective hedge rate declines over time.

The free cash outflow for the first half of £399m (2015: outflow of £576m) was lower than expected, reflecting strong cash collections from a number of key customers at the very end of the period and a better than expected overall working capital performance. Most of this positive variance is a timing impact and likely to reverse early in H2 2016.

A more detailed review of financial performance is included in the Group Trading Summary and the Financial Review.

Positive market developments continue to drive long-term growth in Civil Aerospace

The long-term positive market trends for our leading power and propulsion systems remain unchanged despite some near-term uncertainties in Civil Aerospace that are expected to impact business jet engine production volumes and service activity on older large engines over the next couple of years. The long-term trends driving demand for growth in large passenger aircraft, business jets, power systems and maritime activity remain strong; in particular a growing aspirational and mobile middle-class, particularly in Asia, and globalisation in business, trade and tourism.

While recent political and economic developments have added some uncertainty to near-term utilisation, we continue to expect that strong widebody airframe demand - driven by the need for newer, more fuel efficient aircraft - should provide resilience to manufacturing schedules over the next few years as the industry undergoes a strong replacement cycle.

Transitioning airframes impacting short-term performance

The effects of the transition of the Airbus A330ceo to A330neo models have impacted profitability in line with our early estimates. Once completed, we will benefit from an exclusive position with the new Trent 7000 on the A330neo. In the near-term the profit impact of this transition is negative; the impact of lower pricing and gross margin is exacerbated by the accounting effects of changes within our large engine aerospace product mix as we transition to a portfolio increasingly comprising "unlinked-accounted" engine sales. However, the roll-out of new engines, including the Trent XWB for the highly successful Airbus A350 family, will significantly grow our market share and the installed base of new engines that will deliver strong aftermarket revenues for decades to come.

Good progress in the first six-months of our new transformation programme

The objective of our new transformation programme announced in November 2015 is to simplify the organisation, streamline senior management, reduce fixed costs and add greater pace and accountability to decision making. Our target is to deliver incremental gross cost savings of between £150m and £200m per annum, with the full benefits accruing from the end of 2017 onwards.

A transformation team was set up at the end of 2015 to drive change to simplify processes and activities across the company to deliver sustainable performance improvements, and ensure the other restructuring programmes maintain progress.

In the first half of 2016, these transformation actions resulted in the removal of the divisional structure and a reduction of over 400 in headcount across the management levels of the business. As a result, the initial savings achieved are primarily in indirect costs, particularly at corporate and divisional level.

The management simplification has also enabled early improvements to a number of business processes through clearer delegated authorities and reporting lines together with more efficient management reporting and oversight. As a result, the changes enable management to better direct their efforts onto our core areas of focus and continuous improvement. These encompass engineering excellence, operational excellence and capturing more aftermarket value through leveraging our installed base and improving customer facing activities. Examples include: improving cost-awareness and lead times within product development; reducing production cycle times; and encouragement of local initiatives enhancing customer responsiveness and inventory management across our aftermarket activities.

Good early progress on this programme has meant that the business is well on track towards delivering at the top end of our targeted £30-50m of savings in 2016, which will be second half weighted, with over £100m of annualised savings now identified. As a result we are well on our way to achieving the £150‑200m of annualised cost savings by the end of 2017. Exceptional restructuring charges for this programme were £53m in H1 2016 and we expect to remain within our full year 2016 target range of £75‑100m.

Work is also well advanced to deliver the necessary suite of key performance indicators (KPIs) needed to create a high performance culture. Management information and forecasting tools are being rolled out across the business to simplify the tracking of performance. These include both physical drivers, for example, various measures of delivery performance and working capital management, together with a greater emphasis on forward-looking KPIs. When combined with increased accountability and improved speed and accuracy of data, we believe the tools being put in place will help drive the needed behavioural change and embed greater pace and simplicity within the business culture.

Acquisition of outstanding 53.1% stake in Industria de Turbo Propulsores SA (ITP)

We were notified in early July that SENER Grupo de Ingeniería SA ("SENER") had decided to exercise the put option in respect of its 53.1% stake in Industria de Turbo Propulsores SA ("ITP"). This decision provides us with the opportunity to effectively consolidate several key large engine risk and revenue sharing partner (RRSP) arrangements into the business and strengthens our position on a number of important defence engine platforms and will enable us to enjoy greater benefits from future aftermarket growth.

Under the existing shareholder agreement, the consideration will be settled over a two year period following completion in eight equal, evenly spaced instalments. The agreement allows flexibility to settle up to 50% of the consideration in the form of Rolls-Royce shares. Final consideration as to whether the payments will be settled in cash or cash and shares will be determined by Rolls-Royce during the payment period. Completion, which is subject to regulatory clearances and due diligence, is expected in early 2017.

The acquisition strengthens Rolls-Royce's position on its Civil Aerospace large engine growth programmes by capturing significant additional value from its long-term aftermarket revenues, including the high volume Trent 1000 and XWB engines, where ITP has played a key role as an RRSP. It also enhances the group's own manufacturing and services capabilities and adds value to the Defence Aerospace business, particularly on the TP400 and EJ200 programmes.

Update on regulatory investigations

We previously reported that the Serious Fraud Office had begun a formal investigation. The Group is continuing to cooperate with the authorities in the UK, US and elsewhere. As the investigations are still ongoing we are unable to give any further details or a timescale for when they will conclude.

Shareholder payments

In February 2016 we recommended that the payment to shareholders should be halved at both the full year for 2015 and at the 2016 half year. As we discussed at the time, the pace of investment required to transform the business creates near-term pressure on free cash flow. At the same time, we need to sustain a healthy balance sheet to ensure we have the financial flexibility to maintain a strong investment grade credit rating. We recognise the importance of a healthy 'dividend' to our shareholders and so over time, and subject to short-term cash needs, we intend to review the payment so that it will be progressively rebuilt to an appropriate level. This reflects the Board's long-standing confidence in the strong future cash generation of the business.

As a result, the proposed interim payment for 2016 is 4.60 pence per share, a halving of the interim payment made for full year 2015. As in past payments, the distribution will be in the form of C Shares. Further details are included on page 41 at the end of this statement.

Outlook for the balance of 2016

Our outlook for 2016 is unchanged from that set out in February 2016. On a constant currency basis Group revenue for 2016 is expected to be marginally lower than that achieved in 2015, partially reflecting pricing and volume effects in Civil Aerospace and the continued weakness in offshore marine markets. Overall, the net profit trading headwinds discussed in previous announcements are unchanged.

Individual outlooks are provided for each business in the operating review.

Looking further ahead - long-term outlook remains strong

We continue to see value in the underlying strengths of our business: the underlying growth of our long‑term markets, the quality of our mission-critical technology and services, and strength of customer demand for these which are reflected in our exceptional order book. While we have near-term challenges and some core execution priorities, these constants provide us with confidence in a strong, profitable and cash-generative future.

The successful roll-out of new engines, led in particular by the Trent XWB, 1000 and 7000, together with a growing aftermarket, is expected to drive significant revenue growth over the next ten years as we build toward a 50%-plus share of the installed widebody passenger market. As a result, we remain confident that the important investments we are making to transition our production will create a strong platform to drive customer service and strong cash flows, together with the current investments in new products and the streamlining of our existing product portfolios to ensure we are providing high value, cost-competitive products into our target end markets. 

Expected ongoing benefits of all current restructuring programmes will reduce costs by around £300-350m by the end of 2017

Ongoing divisional restructuring programmes together with the new programme announced in November 2015 are expected to reduce costs by around £300m to £350m. This breaks down to incremental legacy Civil and Defence Aerospace restructuring savings of £80m, Marine savings of £65m and new transformation programme savings of between £150m and £200m.

IFRS 15 Revenue from Contracts with Customers

IFRS 15 is a joint standard for IFRS and US GAAP issuers and introduces new accounting principles for revenue recognition for all types of sales of goods or services. For Rolls-Royce, it comes into force from 1 January 2018 and as a result we will adopt IFRS 15 in both our half-year and full-year 2018 accounts. At that time we will restate the 2017 results, with an opening balance sheet adjustment to equity as at 1 January 2017. 

It replaces existing revenue recognition standards: IAS 11 Construction Contracts and IAS 18 Revenue, and moves away from the 'risks and rewards' concept of revenue recognition used by IAS 18 to a concept of 'transfer of control'. Its core principle is that revenue should be recognised when (or as) an entity transfers control of goods or services.

It is important to remember that, while these changes will be significant, there will be no changes to the treatment of cash flows and cash will still be collected in line with the contractual terms.

We have been working to assess the implications and quantify the impact of the new standard. Our work has confirmed our view that our current accounting is in compliance with existing standards and we will continue to make commercial evaluations on a long-term net present value basis.

We are consulting with other companies in the aerospace and defence sector, so that we can take account of other interpretations in our implementation of the new requirements. Before we can fully assess the impact, we still have a considerable amount of work to do to apply the new standard to the large range of different contracts for our original equipment and aftermarket sales across all our businesses. However, the most significant impact will be in Civil Aerospace. 

As we described in our 2015 Annual Report, based on our provisional assessment, IFRS 15 will have a significant impact on the timing and profile of revenue recognition over the life of individual long-term contracts (without changing the total amount of revenue recognised), although this will be somewhat mitigated when the portfolio of contracts is combined, and in the way we allocate revenue between original equipment and aftermarket sales. 

We have now reached tentative conclusions on several key areas of judgement, as follows:

· We will likely no longer recognise contractual aftermarket rights (CARs)

· We will likely no longer link OE and TotalCare agreements, including where we are currently doing so, and these would then be accounted for separately

· Revenues will likely be recognised as and when we deliver OE and then when we carry out aftermarket services activities

The main impacts of applying these principles to civil large engines are expected to be as follows:

Further work is required to fully evaluate the impact and to prepare for adoption in 2018 including:

· finalise our methodology for recognition of revenue on TotalCare contracts including, for example, the impact on risk and revenue sharing agreements and the impact of acquiring ITP

· modelling the detailed impact on our historical results and to determine the actual transition adjustments at 1 January 2017

· finalise the procedures required to operate under the new requirements

· complete the evaluation and implementation for all businesses (note: our initial evaluations indicate these will be less significant than for the Civil Aerospace large engine business)

The adoption of IFRS15 will enhance the focus on cash efficiency measures. This will be particularly important as we invest in building the installed thrust and manage the transition to being the larger aftermarket business that will provide sustainable long-term cash flows. In parallel to our review of KPIs and future remuneration frameworks, we are working to ensure that future measures work within IFRS15 to provide the right focus on cash efficiency, cash conversion and overall free cash flow performance.

We expect to be in a position to give more detail and an indication of potential impact in Q4.

Board update

During the first six months of the year there have been a number of important changes to the Board. In March we appointed Brad Singer to the Board, at which time he also joined the Science and Technology Committee. In May, following the AGM, Dame Helen Alexander stepped down from the Board having reached the end of her term and was succeeded as Chair of the Remuneration Committee by Ruth Cairnie. In addition, alongside chairing the Science and Technology Committee, Sir Kevin Smith took over the role of Senior Independent Director from Lewis Booth, who continues as Chair of the Audit Committee. Finally, Alan Davies will join the Safety and Ethics Committee with effect from the start of September 2016.

Group Trading Summary

The commentary in this section relates to the Group's operating segments and so, consistent with the requirements of accounting standards, is provided on an underlying basis which is the measurement basis used by the Group in its segment reporting.

As noted in the 2015 Annual Report, the methodology basis for the allocation of Civil Aerospace revenues on linked TotalCare contracts between original equipment and aftermarket was reviewed and amendments made to reflect better the commercial substance of the combined contracts. Historically, the allocation resulted in original equipment revenue and aftermarket revenue reflecting the contractual terms rather than the commercial substance of the contracts. The H1 2015 figures have been restated on the same basis; the impact was an increase in original equipment revenue of £66m and an equal decrease in aftermarket revenue

Order book and order intake

During the year our order book increased by £3.1bn to £79.5bn, led by Civil Aerospace. Key orders included a $2.7bn order from Norwegian for Trent 1000 engines and the selection by China Eastern of 20 Trent XWB powered Airbus A350 aircraft. The order book also benefitted by a £2.1bn uplift from a 5 cent decrease to our long term US dollar planning rate which is used to convert foreign currency orders. Order intake in our Marine business has been low as a result of the continuing weak offshore market. Overall orders were also lower in Defence Aerospace and Power Systems, although we view the prospects for these businesses as unchanged, reflecting long-term orders won in previous years. Order intake in our Nuclear business was higher as a result of submarine programme activity.

Underlying trading

Underlying group revenue declined 5% in H1 2016 compared to 2015 on a constant currency basis, reflecting declines in both original equipment revenue (down 5%) and services (down 5%) and led by Civil Aerospace and Marine. By business on a constant currency basis, Civil Aerospace revenue reduced 5%, Defence Aerospace revenue decreased 1%, Power Systems revenue decreased 3%, Marine revenue decreased 25% and Nuclear revenue increased 14%.

Underlying profit before financing of £158m (2015: £456m) was 70% lower on a constant currency basis, led by a significant reduction in Civil Aerospace profit reflecting previously communicated volume and margin reductions on link accounted Trent 700 engines, reduced business jet original equipment volumes, reduced large engine aftermarket utilisation and increased technical costs for large engines, including the Trent 1000. Profit in Defence Aerospace was £61m lower resulting from a reduction in sales volumes and £31m of costs in support of the TP400 programme. Power Systems was down £6m year-on-year due to lower sales and a product mix effect. Marine profit was £18m lower led by continuing weakness in the off‑shore markets. Nuclear profit in H1 2016 was £3m lower than 2015 due to a lower margin mix in submarine projects

The R&D charge reduced by 3% over 2015 on a constant currency basis, reflecting an increase in the level of capitalisation within Civil Aerospace in H1 2016 and reduced spend in Power Systems.

Underlying restructuring has reduced to £6m (2015: £45m). Charges relating to the transformation activity launched in November 2015 are treated as exceptional in light of the scale of the programme. An exceptional charge of £53m for this programme has been taken in H1 2016. The benefits of cost savings arising from this programme in 2016 are expected to have a second half weighting.

Commercial and administrative costs include accruals for performance incentive schemes in line with our current policies. Given the current state of performance relative to plan, these are currently higher than in the prior year.

Free cash flow

Cash capital expenditure in the first half of 2016 was £307m (2015: £257m), £50m higher, largely reflecting phasing of payments for aerospace footprint and capacity investments. Cash taxes were £62m (2015: £79m). The cash cost of defined benefit pension schemes in excess of the operating profit charge was £10m (2015: £25m).

Overall, the free cash outflow for the first half year was £(399)m (2015: £(576m). The decline in profit, which included a significant non-cash element, was offset by better than expected favourable working capital movements. The TotalCare net asset movement from 2015 year end of £149m reflects the price pressure on the Trent 700 and associated cash deficits. The net asset is now expected to peak between £2.5-2.7bn in the next twelve months reflecting benefits of the changes to our long term US dollar planning rate, further targeted life cycle cost improvements and other timing differences between cost and cash.

Net debt and foreign currency

The Group is committed to maintaining a robust balance sheet with a strong, investment-grade credit rating. We believe this is important when selling high-performance products and support packages which will be operation for decades. Standard & Poor's updated its rating in May 2016 to A-/negative outlook and Moody's maintained a rating of A3/stable.

During H1 2016, the Group's net debt position increased from £111m to £712m, reflecting the £399m free cash outflow, shareholder payments of £168m and £154m for the increased investment in our approved maintenance centre joint ventures following receipt of regulatory approval for the changes to the joint venture agreements in June 2016. In April, we increased our revolving credit facilities by £500m to £2bn to provide additional standby liquidity.

The Group hedges the transactional foreign exchange exposures to reduce volatility to revenues, costs and resulting margins. The hedging policy sets maximum and minimum cover ratios of hedging for net transactional foreign exchange exposure. It allows us to take advantage of attractive FX rates, whilst remaining within the cover ratios. A level of flexibility is built into the hedging instruments to manage changes in exposure from one period to the next and to reduce volatility by smoothing the achieved rates over time.

The most significant exposure is the net US dollar income of approximately $5bn per year which is converted into GBP. Following the fall in the value of sterling which resulted from the outcome of the UK referendum, additional cover has been taken out to benefit from the favourable rates. This has resulted in an increase in the nominal value of the hedge book to approximately $35bn at the end of June (December 2015: $29bn) together with a reduction in the average rate in the hedge book to £/$1.57 (December 2015: £/$1.59). Whilst the majority of the benefit of the favourable exchange rates is likely to impact revenues in the longer term, the flexibility to reduce volatility built into our hedging arrangements should result in a modest benefit to current year results.

Group technical factors for 2016

All figures are at constant translational currencies unless otherwise stated.

Should foreign exchange rates for the full year remain unchanged from those at the end of June 2016, the movements from 2015 rates would improve full year underlying revenues by around £600m and improve underlying profit before tax by around £60m.

There is no change in our guidance on finance charges. Overall underlying finance charges in 2016 are expected to be in the region of £90-110m, partly reflecting the higher level of gross and net debt. The increase also reflects the fact that the underlying financing gain of £34m taken in 2015, on realised foreign exchange contracts settled to convert significant overseas dividends from group companies, is not expected to recur.

There is no change in our guidance on our underlying effective tax rate. The underlying effective tax rate for 2016 is expected to be around 26% reflecting the greater proportion of taxable profit expected to be generated in higher tax rate regions in 2016 compared to 2015.

There is no change in our guidance on capital expenditure. Capital expenditure for 2016 is expected to be around £500-550m (2015: £494m).

Net R&D spend is now expected to be in the region of £900m in 2016, largely reflecting expenses related to the completion of important new product launches in Civil Aerospace.

There is no change to our full year free cash flow guidance. Despite a better than expected first half free cash flow performance our guidance for the full year is unchanged. As a result, free cash flow in 2016 is likely to be in line with previous expectations for a modest overall out flow of between £100-300m.

Operational Review : Civil Aerospace

As noted in the 2015 Annual Report, the methodology basis for the allocation of Civil Aerospace revenues on linked TotalCare contracts between original equipment and aftermarket was reviewed and amendments made to reflect better the commercial substance of the combined contracts. Historically, the allocation resulted in original equipment revenue and aftermarket revenue reflecting the contractual terms rather than the commercial substance of the contracts. The H1 2015 figures have been restated on the same basis; the impact was an increase in original equipment revenue of £66m and an equal decrease in aftermarket revenue

Financial overview

Overall, underlying revenue for Civil Aerospace was 5% lower (down 3% at actual exchange rates) with similar reductions in both original equipment and services.

Original equipment revenues from large engines: linked and other increased 3% reflecting increased sales of Trent 900s which included initial deliveries for Emirates A380s as part of our record $9.2bn order announced last year together with more Trent 1000s for the Boeing 787 Dreamliner. These were partly offset by the slow-down in linked Trent 700 deliveries for the Airbus A330 and associated price pressure ahead of the introduction of the Trent 7000 for the Airbus A330neo. Sales of spare engines to joint ventures generated revenue of £35m (2015 H1: £13m).

Original equipment revenues from large engines: unlinked installed increased 4%, led by higher volumes of Trent XWBs with some reductions of unlinked engine sales from other Trent engine programmes.

Large engine service revenue reduced 6% despite double digit growth in revenues from new engines. The growth was offset by a significant reduction in revenues from our out-of-production engines. The decline included the expected reduced flying hour revenues from lower utilisation of Trent 500 and Trent 800 engines, and reduced time and material sales from fewer overhauls, particularly on older RB211 engines approaching the end of their long-service lives.

Revenues from business jet engine sales were, as expected, lower, particularly for the BR710 engines, reflecting general market weakness and a transition to newer non-Rolls-Royce powered platforms. Volumes of our newer BR725 engine, which powers the Gulfstream G650 and G650ER, remained good. Overall, business jet original equipment revenues declined 18%. Aftermarket revenues for business jets were broadly unchanged.

Services revenues from our regional jet engines declined 17%, reflecting retirements and reduced utilisation of relevant fleets by North American operators.

On the V2500 programme, revenues from original equipment modules declined 21%, as expected, ahead of the end of production of the V2500 engine. Overall V2500 service revenues were 8% higher, reflecting strong flying hour performance as well as a good level of repair and overhaul activity.

Overall gross margins for Civil Aerospace were 12.6% (2015: 19.1%). The main driver of the year-on-year reduction in margin of £243m was the change in mix of large engine sales with fewer link accounted Trent 700 engine sales and price reductions on these engines. Other factors contributing to the reduction were the drop in business jet engine sales, reduced utilisation and less time and material overhauls of our out‑of‑production Trent 500 and 800 and RB211 engines and a declining regional aftermarket.

In respect of long-term contract accounting adjustments, in the first half of 2016 these totalled a net reduction of £(23)m (2015: total benefit of £48m, including a £66m one-off benefit associated with the refinement of our methodology for risk assessment of future revenue). The £(23)m net reduction included a £35m benefit (2015: benefit of £25m) from life-cycle cost improvements. In addition, we recognised in this period a £35m benefit from a 5 cent change (2015: £nil) to our estimated long-term US dollar to sterling exchange rate to bring our own planning rate within updated external benchmark long-term forecast data. These benefits were more than offset by technical costs of £(55)m (2015: £9m benefit) for large engines including the Trent 1000 and a retrospective charge of £(38)m (2015: £(52)m), reflecting other operational changes. The gross margin in H1 2015 included a charge of £17m reflecting losses on Trent 1000 engines which was subsequently capitalised in H2 2015 as contractual aftermarket rights. In H1 2016 all "unlinked" Trent 1000 engines were capitalised as contractual aftermarket rights.

Costs below gross margin were £17m lower than the previous year. Within this, R&D charges of £250m were £10m lower, reflecting increased R&D capitalisation on the Trent 1000 TEN partially offset by higher spend on key programmes, particularly in respect of the Trent 7000 and the Trent XWB-97 which are being expensed ahead of capitalisation and reduced development cost contributions from risk and revenue sharing partners.

Underlying commercial and administrative and other costs were £12m higher than 2015 and included higher accruals for performance incentives. Restructuring costs of £2m were £21m lower, reflecting the significant charges taken in 2015.

As a result, profit before financing and tax was 91% down, reflecting a combination of lower overall gross margins and higher commercial and administrative costs with partial offset from reduced R&D and restructuring costs. Taking account of foreign exchange effects, underlying profit before financing and tax was £31m (2015: £248m).

TotalCare net assets and Contractual Aftermarket Rights

TotalCare net assets increased in H1 2016 by £149m (H1 2015: £62m) to £2.36bn and the CARs balance increased by £71m (H1 2015: £47m) to £476m.

Investment and business development

Order intake of £7.9bn in the first half of 2016 for Civil Aerospace was £0.5bn higher than the previous year. The order book closed at £70.5bn, up £3.4bn or 5% from 2015 year end, which included a £2.1bn benefit from the change in the long term planning foreign exchange rate discussed above. Excluding this the order book was up 2%.

Significant orders during the first half included an order worth $2.7bn from Norwegian for Trent 1000 engines and TotalCare service support for 19 new Boeing 787 Dreamliner aircraft and the selection of 20 Airbus A350 aircraft, powered by the Trent XWB engine, by China Eastern.

In May, Rolls-Royce despatched the first 'shipset' of four Trent 900 engines as part of its largest ever order, for Emirates. Rolls-Royce is providing Trent 900 engines and TotalCare service for 50 Emirates A380s, the first of which will enter service later this year.

The first half saw several notable entries into service, including Ethiopian Airlines becoming Africa's first operator of the Trent XWB and Cathay Pacific Airways becoming the first in the Greater China region. Air China became China's first operator of the Boeing 787-9 Dreamliner, powered by the Trent 1000 engine.

Investment is targeted at achieving improvements in our three core areas of focus: engineering excellence, operational excellence and capturing aftermarket value:

Engineering excellence remains the cornerstone of our value to Civil Aerospace customers

The Rolls-Royce Trent 1000 TEN engine took to the skies for the first time in March, starting a series of test flights and received its European Aviation Safety Agency (EASA) certification on 11 July. The Trent 1000 TEN (Thrust, Efficiency and New Technology) will power all variants of the Boeing 787 Dreamliner family and draws on technologies from the Rolls-Royce Trent XWB engine and Advance engine programme, delivering thrust and efficiency improvements.

In February, Rolls-Royce launched an Enhanced Performance (EP) version of the Trent XWB, the world's most efficient large aero engine, powering the Airbus A350 XWB. The first customer is Singapore Airlines. The Trent XWB-84 EP goes beyond the original Trent XWB-84 performance target levels, offering a fuel consumption improvement of 1%. The Trent XWB-84 EP incorporates technologies from the higher thrust Trent XWB-97 engine, the Advance engine programme and other future technology research.

The Advance3 large engine demonstrator started build in our Bristol facility. The demonstrator will test the new core architecture for future engine families and other key technologies such as Lean Burn combustion, Ceramic Matrix Composites, CastBond™ (specialist turbine manufacturing) and additive layer manufacturing or 3D printing.

Rolls-Royce's German joint venture for power gearboxes, a key technology for the UltraFan™ engine, delivered the first gearbox hardware and commissioned its attitude rig.

Investing in new aerospace supply chain capabilities to help drive operational excellence

Rolls-Royce announced plans to invest more than £30m at its site in Washington, Tyne & Wear, UK, creating a new facility to manufacture a range of aerospace discs for in-service engines. The new Fleet Support plant is expected to be fully operational in 2018 and will sit alongside our world-class UK discs manufacturing facility, which officially opened in June 2014. The new facility will have the capacity to manufacture well over 1,500 fan and turbine discs a year for use in a wide-range of existing engines, in both Civil and Defence Aerospace applications.

Strengthening our aerospace aftermarket service offering

Rolls-Royce and its partners have received regulatory approval and met all other closing conditions for its previously announced changes to three Approved Maintenance Centre (AMC) joint ventures. AMCs support Rolls-Royce's strategy to develop a competitive, capable and flexible Trent service network to meet the changing needs of customers across the lifecycle of engines and to support the growing Trent engine fleet. In June, we invested £154m to increase our stake in both Hong Kong Aero Engine Aero Services Limited (HAESL) and Singapore Aero Engine Services Pte Ltd (SAESL) to 50%.

Rolls-Royce also announced that it is further expanding its global network of Authorised Service Centres (ASC) for business aviation aircraft under its CorporateCare service provision for customers. Rolls-Royce now has 62 ASCs in place with key maintenance providers worldwide, meaning that CorporateCare customers will benefit from streamlined administration and reduced maintenance time.

Civil Aerospace outlook

We continue to expect our Civil Aerospace business to underperform 2015 underlying profit before finance and tax by around £550m, excluding foreign exchange benefits. The significant headwind related to Trent 700 volume reductions and the non-recurrence of a number of one-off benefits seen in 2016 remains broadly unchanged.

In the second half we expect the business to benefit from higher large engine deliveries for widebody aircraft, including spare engines to support the growth in our fleets, further life-cycle cost improvements within our TotalCare contracts and the benefits of our restructuring activity. We remain cautious about the weak business jet markets.

We expect the TotalCare net asset to peak in the next twelve to eighteen months at between £2.5bn and £2.7bn, reflecting benefits of the changes to our long-term US dollar planning rate, further targeted life cycle cost improvements and other timing differences between cost and cash.

Operational Review: Defence Aerospace

\* Translational foreign exchange impact ** 2015 year end comparative

Financial Overview

Underlying revenue of £1,002m was marginally below the prior year on an underlying basis (up 3% at actual exchange rates). Higher volumes on both LiftSystemTM and TP400 production, together with increased Adour engine deliveries to Saudi Arabia, helped original equipment revenues increase 8%, on an underlying basis. Service revenues were 6% lower than the prior year, mainly due to lower spares sales on a number of legacy programmes, while long-term service contract revenues were broadly in line with the prior year.

Gross margin declined by £76m, reflecting the lower sales of spare parts and an adverse change in OE product mix plus expected additional expenditure of £31m on technical improvements to the TP400 programme. Retrospective margin improvements on existing long-term contracts reflecting cost improvements totalled £44m, similar to the prior year. These improvements are expected to be principally first half weighted.

Overall R&D costs were similar to the prior year as the business continued to invest in future programme development, while restructuring costs were lower due to reduced level of severance costs and lower spend on the closure of the defence facility at Ansty. Underlying commercial and administrative costs and other costs were similar to prior year despite higher accruals for performance incentives in 2016. 

Profit before financing of £128m was 33% lower than the prior period.

Investment and business development

Order intake for H1 2016 was £743m (2015: £821m). Overall, the Defence Aerospace order book declined by 4%, in part reflecting the timing of a number of expected orders which should be received in the next few quarters. The first half saw continued interest in our Services portfolio from major customers including the contract renewal from the US Department of Defence to support AE 2100 engines powering its C-130J transport fleet. We also delivered the first T56 3.5 technology insertion kits to the USAF which offer both fuel saving and performance benefits for its legacy C-130 fleet. International interest in this technology upgrade continues to be strong.

We received a follow-on production contract for the LiftSystem for the F-35B and recently signed an memorandum of understanding with Pratt & Whitney to extend our aftermarket support for the UK's new F‑35B Lightning fleet beyond the LiftSystem. The opening of the Kingsville Service Delivery Centre (SDC) in Texas strengthens our local service offering for the US Navy's T-45 Goshawk trainer fleet and provides further opportunities to develop the service relationship. A number of new SDC facilities are due to be rolled out over the next 12 months as we pursue this strategy of closer proximity to our major customers.

We continue to work on positioning ourselves to be competitive for forthcoming indigenous combat programmes, and see further combat opportunities following the UK and French Governments' commitment to the €2bn FCAS unmanned combat air system programme. In addition, we signed agreements with both MD Helicopters and Enstrom which offer new opportunities for our small helicopter engines. Our commitment to development of cutting-edge technology was boosted by the selection of our LibertyWorks development unit to provide the vertical lift propulsion for the new DARPA VTOL X-Plane.

As well as some organisational rationalisation, the transformation programme within the Defence Aerospace business has focused on the upgrading of the Indianapolis operations facilities which will deliver both operational efficiencies and greater development capabilities. Performance against transformation milestones ran to plan in the first half. Defence Aerospace capital expenditure rose modestly as the investment activity in Indianapolis increased.

Defence Aerospace outlook

The business continues to invest in important product development and manufacturing transformation initiatives as it looks capitalise on its strong positions, particularly in Combat and Transport & Patrol. As a result, margins are expected to soften from the highs seen in 2014 and 2015.

Expectations for full year performance are unchanged. Revenues should remain steady, with margins continuing to reflect the investments in long-term growth and additional actions to offset the TP400 expenditure.

Operational Review: Power Systems

Financial overview

Underlying revenue of £1,084m was 3% lower (4% higher at actual exchange rates). Original equipment revenue was 3% lower, reflecting a lower level of naval and rail project-related sales compared to 2015 and the impact of the low oil price on marine offshore and fracking activities in particular, with some offset from higher power generation, construction and agriculture sales. Low oil and commodity prices were the most significant contributors to the 2% reduction in underlying service revenues, where industrial markets were most impacted.

Gross margins were marginally lower at 23.4% (2015: 23.6%) reflecting volume reductions leading to higher overhead allocations as well as some changes to the product mix.

Underlying profit declined £6m or 35%. Commercial & administrative costs were £3m higher. The £5m reduction in R&D reflects a more focused approach to future product development activity. Other costs below gross margin were broadly unchanged.

Investment and business development

Our Power Systems business serves a variety of markets ranging from marine, industrial, construction & agriculture to defence and power generation. This diversity has enabled the business to mitigate some of the weak market environment, particularly those linked to oil and commodities.

H1 2016 order intake was £1.2bn (2015: £1.3bn) with the year-on-year reduction mainly from oil and gas and commodity related markets together with lower rail and government project orders. Despite this, the order book closed up from the end of 2015 at £2.0bn (2015: £1.9bn).

We have continued to develop our position in the energy segment. In March, we signed a strategic agreement with VPower Group to strengthen our partnership in power generation markets across China and the rest of Asia. We also established a 50/50 joint venture with China Yuchai International Limited's main operating subsidiary, Yuchai Machinery Company Ltd, for the production under licence of MTU Series 4000 diesel engines in China for the Chinese off-highway market, for power generation and for oil and gas applications.

We have had several good contract wins for our naval and marine products. These include an order for twelve MTU diesel gensets for the UK Royal Navy's Type 26 Global Combat Ship and a contract win for six MTU engines from Istanbul based Bilgin Yachts. We have also been selected to supply MTU-branded engines to crane producer Kato for the first time. Winning Kato as a customer represents our first success in the high-tech Japanese crane market and we expect Kato to source several hundred units per year.

Power Systems outlook

The Power Systems outlook is cautiously positive. The business finished the first half with a solid order book and good order coverage in several key longer cycle markets including power generation and governmental, broadly consistent with the prior year. Markets continue to be mixed, with some industrial markets remaining soft, as demonstrated by comments from some of our customers and competitors. While there is much to do in the second half, we expect our diverse end market mix to help mitigate this.

Operational Review: Marine

\* Translational foreign exchange impact ** 2015 year end comparative

Financial overview

Underlying revenue of £548m was 25% lower (down 21% at actual rates). Within this, original equipment revenues were down 30% and service revenues declined 17%, primarily due to the downturn in the offshore market.

Gross margins increased 220 basis points to just under 20% and overall gross margin was £108m, £18m lower than in 2015. Despite the sharply lower revenues, gross margins were largely held as a result of the non-repeat of last year's £30m contract provision which impacted the first half of 2015. As a result, the business reported an underlying loss of £(13)m, compared to a profit of £4m in H1 2015

Investment and business development

The order book declined 22% during the first half of this year, with order intake of £362m, 36% down on H1 2015. In particular, the offshore market has remained very weak, with the low level of OE revenues reflecting the impact of the continued low oil price and reduced investment by oil majors. Service revenues have been more resilient, although also at subdued activity levels.

We have continued to look for opportunities to extend our differentiated technology into non-oil related adjacent markets including for other support, fishing and research vessels. These applications place a similar value on the high-performance characteristics of our Marine products. One of the most interesting contract wins will be to design and equip the UK's new polar research ship, the RRS Sir David Attenborough. In addition, there have been a number of opportunities within the cruise ship sector, including a £25m order to design and equip up to four new Hurtigruten polar cruise vessels to operate off the coast of Norway, announced in July (and therefore not in the closing order book).

The Naval business has continued to perform well, having a strong first half compared to the prior year. This included delivery of the first MT30 gas turbine for the UK's new Type 26 Global Combat Ship, and the successful sea trials of the USS Zumwalt. The MT30 was also selected by a new customer, the Italian Navy.

Product development work within the business included increasing our R&D focus on ship intelligence to develop a range of products that can monitor equipment performance in real time, and help facilitate full ship automation in the long-term.

We have also recently announced plans for a significant investment in our azimuth thruster production facility in Rauma, Finland. The £44m project will create a state-of-the-art production facility for one of our most important product groups.

The marine restructuring programme remains on track, following last year's proposals to reduce our workforce by 1,000. By the end of this year, we will have reduced our Marine workforce by around 20% since 2014. We continue to assess further cost restructuring opportunities.

Marine outlook

With the continued decline with offshore oil & gas markets impacting revenues the Marine business is becoming more balanced across its different end markets. As a result, business performance is starting to more visibly reflect the benefits of restructuring and its strong positions in Naval and Merchant, positive features as the business looks to the next few years.

However, in the near-term, expectations for the second half 2016 remain challenging. While the stronger Naval and Merchant order book at the end of H1 provides some comfort for achieving expectations for the full year, when combined with the ongoing focus on cost reduction, there are continued weaknesses in offshore oil & gas and potential order cancellations. As a result, we continue to expect revenues and profits to be lower than those seen in the second half of 2015.

Operational Review: Nuclear

Financial overview

Underlying revenue increased 14%, led by growth particularly in original equipment activities in the submarines business. This reflects the phasing of programmes across next generation and refuelling projects as well as acceleration of the Vulcan test facility decommissioning.

Gross margin was lower at 14.3%, reflecting the product mix favouring lower margin government-led submarine projects. Below gross margin, the change in treatment of R&D tax credits, which significantly impacted the full year in 2015, produced an R&D credit of £3m in the first half (H1 2015: nil), offset by increased costs to support the increased volumes and higher performance incentives within commercial and administrative costs. As a result, underlying profit before financing was £3m lower than the prior year, at £18m.

Investment and business developments

While order intake of £144m was £49m higher than the prior period, the order book was £210m lower at £2.0bn, reflecting the phasing of MoD order releases and both delays and contract phasing within civil nuclear programmes in the UK, North America and Europe.

Our civil nuclear business, which focuses on multi-year engineering projects and specialist technical services, concentrated its first half activities on its long-term instrumentation & controls retrofit contracts in France and Finland, together with the integration of the US R.O.V. Technologies business (a provider of complementary remote visual inspection services) acquired last year. In March, Nuclear also announced the strengthening of the strategic collaboration started in 2014 with the China National Nuclear Corporation, CNNC. This includes specific engineering, consultancy and training services to be provided by Rolls-Royce in a market expected to continue to grow strongly and where we have a strong technology presence.

Our submarine activities focused on performance improvement initiatives to support its long-term contracts for the UK Royal Navy's nuclear submarine fleet, including delivery of the nuclear propulsion system to power the Astute class submarines. Development work on the new PWR3 power plant for Successor (the next generation of Trident submarines) continues with contract extensions agreed in preparation ahead of the government final investment decision. Work on the older Vanguard-class Trident submarines included implementing a refuelling programme. In addition, progress continues on the decommissioning of the Naval Reactor Test Establishment, HMS Vulcan, in Scotland.

An R&D programme was initiated together with a number of partners to scope out the initial design phase for Small Modular Reactors. These smaller, more flexible units offer the potential for lower cost/lower scale and more flexible power generation in future decades and directly build on the knowledge and specialist skills of our Rolls-Royce Nuclear business.

Transformation projects within the Nuclear business have focused on operational improvements and on people and culture. The organisational design and management reduction is on track to deliver against committed cost saving targets.

Nuclear outlook

The long-term outlook for Nuclear remains positive, with both the civil and submarine businesses focused on delivering cost-effective and value-added products and services with on time deliveries to their core customers under long-term secure aftermarket contracts. Confirmation by the UK Government of the ongoing investment in the Successor submarine programme to replace Trident, together with renewed activities in the civil market, particularly in China, provide encouraging growth opportunities.

In the near term, our focus is on sustaining the recent operational improvements at our key UK facility to improve delivery performance. At the same time we will be making the modest investments set out above to explore the technical and market opportunities for Small Modular Reactors. As a result, while revenues and gross margins are expected to be largely unchanged year on year, full year profit is expected to be lower. 

Financial review

Underlying income statement

Segmental analysis

Underlying revenue and underlying profit before financing are discussed in the Business Highlights (page 3), the Group Trading Summary (page 9) and the Operational Reviews (page11).

Underlying financing costs increased by £37m to £54m. Net interest payable increased by £7m to £35m due to the issue of $1.5bn of debt in the second half of 2015 and other underlying financing costs increased by £6m to £19m. In addition, an underlying gain of £24m in 2015 on realised foreign exchange contracts which were settled to convert overseas dividends into sterling did not recur.

Underlying taxation was £27m, an underlying tax rate of 26% compared with 23% in 2015.

Underlying EPS decreased 77% to 4.20p, in line with profit for the period.

Payments to shareholders are made in the form of C Shares, details of which are set out on page 41. An interim payment of 4.6p per share will be made.

Reported income statement

The changes in 2016 resulting from underlying trading are described in the previous sections.

Consistent with past practice and IFRS, the Group provides both reported and underlying figures. We believe underlying figures are more representative of the trading performance, by excluding the impact of period-end mark-to-market adjustments, principally the GBP:USD hedge book. In addition, post-retirement financing and the effects of acquisition accounting are excluded. The adjustments between the underlying income statement and the reported income statement are set out below and in more detail in note 2 to the Condensed Financial Statements. This basis of presentation has been applied consistently.

Reconciliation between underlying and reported results

The mark to market adjustments are principally driven by movements in the GBP:USD and EUR:USD exchange rates which moved from 1.48 to 1.34 and from 1.09 to 1.11 respectively during the period 1 January 2016 to 30 June 2016. At each reporting date our foreign exchange hedge book is included in the balance sheet at fair value ('mark-to-market'). The movement in this valuation during the period, after taking account of contracts settled, is included in the reported profit. As the Group has a large hedge book ($35bn), the movements can be significant, depending on changes in exchange rate. In H1 2016 this resulted in a charge of £2,155m.

The hedge book is held to manage the impact of changes in exchange rates on future foreign currency income. Accordingly, non-cash changes in its value are excluded from the underlying results as they do not relate to the trading in the period.

Movements on other financial instruments relate to exchange differences on risk and revenue sharing arrangements.

The effects of acquisition accounting in accordance with IFRS 3 are excluded from underlying profit so that all businesses are measured on an equivalent basis. In addition, the impairment charge in Marine of £69m was excluded in 2015.

Costs associated with the substantial closure or exit of a site, facility or activity and significant organisation transformation are classified as exceptional restructuring and excluded. In 2016, these increased by £57m primarily representing costs of the transformation programme.

Profits and losses arising on acquisitions and disposals during the year are excluded.

Net financing on post-retirement schemes is excluded from underlying profit.

Appropriate tax rates are applied to these adjustments, depending on the relevant tax jurisdiction, the net effect of which was a reduction of £405m to the underlying tax charge (2015 £152m reduction). In 2016, the most significant tax adjustment was £377m in relation to mark-to-market adjustments of £2,155m. These are predominantly held in the UK.

Summary balance sheet

1 Net working capital includes inventories, trade and other receivables, trade and other payables and tax assets and liabilities (other than deferred).

2 Net funds includes an asset of £332m (2015 asset £13m) of the fair value of financial instruments which are held to hedge the fair value of borrowings.

3 Other includes other investments and deferred tax assets and liabilities.

Intangible assets (note 8) increased by £345m mainly due to exchange differences of £314m. Additions of £232m (including £39m of certification and participation fees, £54m of development costs and £90m of contractual aftermarket rights) were largely offset by amortisation of £199m.

The carrying values of the intangible assets are assessed for impairment against the present value of forecast cash flows generated by the intangible asset. The principal risks remain: reductions in assumed market share; programme timings; increases in unit cost assumptions; and adverse movements in discount rates.

Property, plant and equipment (note 9) increased by £228m. Additions of £191m were largely offset by depreciation of £195m. Exchange differences were £206m and £41m was added from the reclassification of joint ventures to joint operations.

The net post-retirement scheme deficit surplus/(deficit) (note 11) has increased by £218m largely due to movements on discount rates in the period. In the UK, the discount rate reduced from 3.6% to 2.7%, which was the main component of an increase in pension liabilities of £1.7bn. As the pension assets are managed to hedge changes in the valuation of the liabilities, these increased by £2.2bn, a net movement in the UK of £0.5bn. The deficit on overseas schemes increased by £0.3bn (including £0.1bn of foreign exchange) as many of these (most significantly in Germany and US healthcare schemes) are unfunded and consequently the reduction in the discount rate increases the post-retirement liabilities with no off-setting change in assets.

Movements in net funds are shown overleaf.

Investments in joint ventures and associates increased by £189m largely due to a £154m increase in the Group's share of Approved Maintenance Centre joint ventures. The reclassification of joint ventures to joint operations (£57m, see page31), was broadly offset by exchange gains of £47m.

Provisions largely relate to warranties and guarantees provided to secure the sale of OE and services. The increase of £137m includes reclassifications from accruals of £92m, following a review of accounting consistency during the period. The remaining increase of £45m includes additional charges of £132m, principally for warranty and guarantees and restructuring, and foreign exchange movements of £50m, offset by utilisation of £100m.

Net financial assets and liabilities relate to the fair value of foreign exchange, commodity and interest rate contracts, financial RRSAs, set out in detail in note 10. All contracts continue to be held for hedging purposes. The fair value of foreign exchange derivatives is a financial liability of £3.7bn, an increase of £2.1bn in the period, mainly a result of the strengthening of the US dollar.

The US$ hedge book increased by 20% to US$35bn. This represents around 5½ years of net exposure and has an average book rate of £1 to US$1.57.

Net TotalCare assets relate to Long-Term Service Agreement (LTSA) contracts in the Civil Aerospace business, including the flagship services product TotalCare. These assets represent the timing difference between the recognition of income and costs in the income statement and cash receipts and payments.

Customer financing facilitates the sale of OE and services by providing financing support to certain customers. Where such support is provided by the Group, it is generally to customers of the Civil Aerospace business and takes the form of various types of credit and asset value guarantees. These exposures produce contingent liabilities that are outlined in note 12. The contingent liabilities represent the maximum aggregate discounted gross and net exposure in respect of delivered aircraft, regardless of the point in time at which such exposures may arise.

The reduction in gross exposures is a result of guarantees expiring.

Summary funds flow statement

Movement in working capital - the £235m increase includes higher levels of inventory due to a forecast increase in deliveries in the second half of the year, partly offset by an increase in deposits and advance payments. The increase is lower than the previous year, reflecting the increase in deposits and a reversal of the payables reduction experienced in 2015 due to the timing of sales and purchases.

Expenditure on property, plant and equipment and intangibles - the increase largely reflects higher capital spend (£50m), certification costs (£23m), capitalised development costs (£45m) and contractual aftermarket rights (£16m).

Pensions - the reduction in pension contributions in excess of the income statement charge arose principally in the UK due to a reduction of deficit reduction payments and the non-recurrence of a past-service credit in 2015.

Shareholder payments - the change in shareholder payments reflects the difference between the 2014 and 2015 interim payments, which are paid in the following January. The reduction in shareholder payments announced in February 2016 will be reflected in cash from the second half of 2016.

The derivation of the summary funds flow statement above from the reported cash flow statement is included in the appendix. 

Condensed consolidated income statement

For the half-year ended 30 June 2016

All activities comprise continuing operations.

Condensed consolidated statement of comprehensive income

For the half-year ended 30 June 2016

Condensed consolidated balance sheet

At 30 June 2016

Condensed consolidated cash flow statement

For the half-year ended 30 June 2016

The movement in net funds (defined by the Group as including the items shown below) is as follows: