Description

We had first looked at Rolls Royce in 2014 but felt it was too expensive so we set a price and added the company to our watchlist.  Following a string of four profit warnings within an eighteen-month period, the share price fell from a peak of £12.75 at the start of 2014 to a low of £5.13 in November 2015.    Businesses encountering difficulties often provide fertile hunting grounds for value investors so we decided it was worthwhile investigating whether the problems facing the company were fixable and short-term or rather more long-term and structural in their nature.  

Overview of the business

The company’s aerospace businesses develop and manufacture gas turbine jet engines used to power both civil and military aircraft.  The civil and defence aviation units combined generated 60% and 75% of 2014 revenue and operating profit respectively.    In addition, the company has three other operating units: Power Systems, Marine and Nuclear.

Power Systems manufactures diesel engines used to provide propulsion for applications in the, railway, mining and agricultural industries.  The division also manufactures diesel and gas powered electricity generators used to provide local onsite electricity generation. Competitors include Caterpillar, GE and Cummins.

Marine offers a wide range of products for shipping and offshore oil and gas production including gas turbines, propulsion equipment, reciprocating engines, motion control & handling systems, deck machinery, ship design and automation and control systems.  The company focuses mainly on offshore drilling, tankers and commercial shipping with less exposure to cruise liners where performance and reliability requirements are lower.   Whilst cyclically challenged, Rolls Royce is unparalleled in the provision of engines and ancillary products which can cope with the hostile environment in which these products have to operate.

Finally, the company’s nuclear division exclusively builds engines for the UK’s fleet of nuclear powered submarines.  In 2006 the company entered the civil nuclear industry making parts and providing the associated aftermarket servicing for nuclear power stations.  The company’s components and systems are installed in around half of the world’s operational nuclear reactors.

Aerospace engines – a duopoly with predicable long-term cashflow dynamics

The company’s crown jewel is its aerospace businesses.  The design and manufacture of engines for aviation is a market where the level of rivalry has fallen in the last ten years.  The extensive scale advantages and experience curve of the incumbents present a significant challenge for any potential new entrants into these markets.  

R&D and development costs of over US$1.5Bn to develop a new engine has led the industry to consolidate and forced competitors to collaborate in consortia to share development costs and reduce risk.  The civil aviation market is typically divided by industry commentators into four segments defined by aircraft size: business jets, regional jets, narrow-body and wide-body.  Currently Rolls Royce provides engines for the business jet and wide-body segments having exited the narrow-body segment after it sold its 32.5% stake in the aircraft consortium International Aero Engines (IAE) for US$1.5Bn in 2011. 

In the wide-body segment Rolls Royce competes in a duopoly with GE’s aviation division.  Rolls Royce has ~30% market share of the current global installed base of wide-body engines but over 50% of the industry’s current order book. The requirement for scale has enabled GE and Rolls Royce to ensure that they are the exclusive supplier of engines for several of Boeing and Airbus’ aircraft, for example the A350 in the case of Rolls Royce and 777X for GE.  In the business jet market Rolls Royce competes less effectively with GE, Safran, Pratt & Whitney and Honeywell. 

The defence division offers engines, in a number of cases as a sole source supplier, for various fixed wing aircraft and helicopters including the Eurofighter Typhoon, V-22 Osprey, C-130 Hercules, A400M, Eurocopter Tiger and Bell Warrior.  It also provides the vertical lift system for the fifth generation F-35B fighter plane.

Long-term visibility of maintenance cashflows

The core business is not so much the sale of the engines themselves but the highly profitable maintenance, repair and overhaul (MRO) business which can be won on the back of the sale of original equipment.  Over the lifetime of the engine (typically 25 years), MRO represent a revenue opportunity 4 times the cost of the original engine.  Rolls Royce and its competitors typically sell engines at a cash loss but make up for the upfront loss with highly profitable MRO contracts.  There is an increasing trend in the industry for original equipment manufacturers such as Rolls Royce to bundle engine sales and aftermarket services together.  Rolls Royce has been a pioneer in pushing this business model with c.90% of its wide-body ‘Trent’ series of engines now sold with long-term maintenance agreements which typically run for up to 15 years.

Rolls Royce’s position as an original equipment manufacturer provides a competitive advantage versus independent MRO companies.  The company’s operation room in Derby continuously asses the performance of over 3,500 engines in operation globally.  This installed base of engines generates 22 million engine ‘health monitoring’ reports which the company analyses annually.  The volume of proprietary data collected provides a moat against competition as it enables Rolls Royce to predict when engines are likely to fail, improving the efficiency of maintenance scheduling and replacement of engine parts.  The accumulation of proprietary engine performance data also helps Rolls Royce to modify existing engines and develop future engines which are more reliable and fuel efficient.

Airlines have become much simpler businesses and are generally deskilling in the area of technology.  Some airlines have been running dual programmes where they have compared total care to DIY and there is evidence of the DIY decreasing.  Airlines, especially start-ups in emerging market, like the predictability of a per flight-hour cost. 

Aftermarket services contributed 52% of civil aviation’s revenue in the first half of 2015, up from 40% in the early 2000s and 25% in the early 1990s.  The share of aftermarket revenue in the company’s aviation defence business is even higher at 61% in H1 2015.  Civil aviation’s share is forecast to grow closer to 80% in the future. 

A growing market which is capacity constrained

Furthermore, these engines and MRO contracts are sold into an attractive market with the “tail-wind” of future growth in aviation travel projected at 3-4%, slightly lower than the 5% growth achieved over the last 35 years. .  The industry is currently capacity constrained with both Airbus and Boeing struggling to meet demand for new aircraft.  This pent up demand has led to OEMs, including Rolls Royce, amassing large order books which cover up to a decade of future deliveries. 

The bear case is extensive

Today, with only a small amount of debt, Rolls Royce business is trading at a multiple of the average of the last five years operating profit of 8.7x.  One would expect that a company such as Rolls Royce with compelling underlying economics and high visibility of future growth should be more highly valued by the market.  We spent a lot of our research activity trying to understand the bear case.

1.    Airbus introduction of new model for the A330 in 2017

Rolls Royce’s most successful engine in recent years has been the Trent 700, which is attached to the Airbus A330ceo aircraft.  The company is now experiencing a decline in orders for these engines and pressure on prices as airlines wait for the introduction of Airbus’ new version of this aircraft, the A330neo, scheduled to enter service in 2017.  This new aircraft will be exclusively powered by Rolls Royce’s new Trent 7000.  Management forecasts this transition period will have a marked impact on near term reported profitability, reducing profits by £250m in 2016 through a combination of decline in units sold and average selling price.

These transition pains should prove to be only temporary.  Orders for the new A330neo with its attached Trent 7000 engine will start making up for declines in its predecessor when it enters service.  In addition, Rolls Royce will see further growth from its Trent XWB engine as the A350 production ramps up from 14 aircraft in 2015 to its target of 10 per month in 2018.  In the meantime reported profits will likely decline.  This forecasted decline will be further exasperated by a technicality in the accounting of engine sales which means future profit from aftermarket services cannot be booked upfront for the Trent 7000 or Trent XWB in the way it was for the Trent 700.  The short-term impact on profits may put continued pressure on the share price. 

2.    Impact of lower oil prices on Marine division

The company’s marine division, which contributed 8% of operating profit in 2014, is being severely impacted by the challenges faced by the offshore oil & gas industry, which accounts for 60% of the division’s revenue.  Management claims the current business environment is the toughest they have ever experienced.  The division’s operating profit in 2014 was down 50% to £138m vs. 2013 and guidance for 2015 is for the business to only generate between £0m to £40m.  Given the difficulty in predicting where oil and gas prices will settle in the medium to long-term we have conservatively assumed long-term operating profits going forward are 60% below their peak achieved in 2010.

3.    Accounting

The provision of long-term maintenance contracts and the bundling of these contracts with original equipment sales complicates the company’s accounting and makes it difficult to determine the standalone profitability of engine sales and aftermarket services.  This in turn obscures the long-term free cash flow generating power of the business.

The nature of the long-term MRO contracts signed with customers also requires the company to estimate the long-term costs to maintain and service the engines through the life of the contract.  By signing up airlines to these long-term maintenance contracts there is a risk transfer between Rolls Royce and its customers in essence it represents a type of insurance policy.   The need to make long-term estimations of future costs provides room for accounting shenanigans i.e. underestimating future costs can be used to boost short-term reported profits.  There is also the risk there might be unforeseen future engineering problems with new engines which have not been anticipated in cost estimations. 

We had to get comfortable that it is realistically feasible for Rolls Royce to price these contracts and that they are doing so conservatively.  We attempted to do this by tackling the problem from several angles.  The first was to compare Rolls Royce’s accounting practices with that of competitors to test whether it taking a more aggressive approach relative to its peers.  It appears its competitors are using similar accounting standards as Rolls Royce in their revenue and profit recognition on original equipment sales and the booking of profits tied to long-term aftermarket service contracts.  Just because the company is acting in line with its peers does not guarantee it is behaving conservatively.  As Warren Buffett said in 2006 ‘The five most dangerous words in business may be “Everybody else is doing it”’. 

We took our analysis further by speaking to people close to the company to understand the underlying corporate culture. We learned that a cultural conservatism runs through the business.  One example is the company does not assume future cost reductions in engine maintenance as it moves down the experience curve when pricing long-term maintenance contracts.  These likely future cost savings are never recognised in the accounts until they are delivered.  In 2014 the company was able to book a profit of £150m as estimations the company made for costs associated with future maintenance services proved to be too conservative.   As a further layer of conservatism, management also incorporates an ‘estimation’ risk into its pricing of contracts as a margin of safety against potential errors. 

Engine development tends to be more evolutionary than revolutionary with a number of incremental improvements adding up over time leading to significant performance improvements.  This provides reassurance in that historical engine performance data should provide a good basis on which to predict the performance and operating characteristics of new generations of engines given they share similar ‘DNA’.  The final test was to follow the cash.   Historically over long periods, the company’s profit to cash conversion has been reassuring high. 

4.    Margin gap

Rolls Royce’s aerospace business has consistently lagged behind its rival GE in terms of operating margin.  The gap has averaged 600bps since 2007.  The company acknowledges this poses a strategic risk as it could enable its rival to out invest it in the development of future engines.

We are confident that some of this margin gap can be closed through through improved operational efficiency and the strengthening of its negotiating position with suppliers.  In is his comments to investors the new CEO Warren East, who was appointed in July last year, has made it clear he sees significant possibilities for operational improvements by changing the rather sleepy culture running through the business.

Advances in production technologies such as 3D ceramic printing, a technology GE has been pioneering the use of, should provide opportunities for Rolls Royce to increase its share of profit of the industry’s value chain.  The emergence of these new fabrication techniques should allow Rolls Royce to either take more engine production in house or use the threat to negotiate harder with suppliers from which it has historically sole sourced.

However, these factors will likely only enable Rolls Royce to partially close the margin gap.  The company’s smaller scale puts it at an intrinsic disadvantage against its larger rival GE.  On a standalone basis GE Aviation’s revenues are 1.6x greater than Rolls Royce’s combined civil and defence aviation businesses.  When you combine GE’s revenues with that of the French aviation propulsion company Safran, with which it has a 50:50 JV, it puts the combined relative market share of the two competitors at 2.4x to that of Rolls Royce.   Historic studies of the aviation industry have shown experience curves in the range of 85% i.e. every doubling of cumulative production results in a 15% reduction in costs.  The industry’s underlying economics suggest a cost disadvantage will remain even if new management is successful in improving operational efficiency (a factor we have not modelled in our valuation as it has yet to be proved).

This issue could have been sufficient for us to kill Rolls Royce as an idea for our fund.  Businesses with a long-term structural cost disadvantage to its competitor(s) are difficult to value.  However, an alternative way of thinking about Rolls Royce from a competitive perspective is to split it into two parts:

a.         Rolls Royce’s current global installed base of engines and its order book:  for these engines, the competition with GE is already over and as discussed above, Rolls Royce has signed long-term MRO contracts on 90% of the engines ordered.  Some of this revenue is predictable to 2050 (order book going out 10 years plus 25 years of engine life) and on this revenue stream, Rolls Royce is the monopolistic supplier of services with inflation+ pricing the opportunity to increase margin over time through further operational efficiencies.    Our assessment of the discounted future cash flows generated from the aftermarket contracts attached to the current active fleet of engines and its current firm order book is greater than Rolls Royce’s current entire enterprise value. 

b.         Future engines (2024 and beyond):  With its superior fuel efficient Trent XWB, the engine which powers the new A350, Rolls Royce is enjoying a short-term (but multi-year) edge over GE.  This has led to Rolls Royce taking a greater than 50% market share of the order book, which is forecasted to lead to a greater than 50% share of the installed base of wide-bodied engines within the next ten years.  We expect and model that this will change and it will start to lose share after 2025 as GE is able to catch up and fight back leveraging the scale advantage it has from operating in both the wide and narrow body markets.    Nevertheless, it is not in GE’s interest to price its only competitor out of the industry as doing so would cost it a vast amount of money and would inevitably lead to heavy regulatory scrutiny, especially in Europe.   We believe there is a long-term role for Rolls Royce in the provision of engines for the wide-body market.

5.    Industry cyclicality

The civil aviation industry is exposed to cyclical downturns as seen after the 9/11 terrorist attacks and during the financial crisis.  These industry downturns can lead to cash flow issues for Rolls Royce as they invoice customers by hours flown.  As airline activity declines in a downturn the company experiences a drop in monthly incoming cash flow.   Our concern would be that in an extreme downturn the company might be forced into doing a rights issue diluting existing shareholders at unattractive prices.  We analysed historical declines in passenger numbers during periods of industry distress.  For example after the 9/11 attacks and during the financial crisis global civil aviation traffic declined by -2.7% and -2.1% respectively.  We used these scenarios for stress tests to our valuation model to see the impact on free cash flow generation.  Our analysis suggests Rolls Royce should be able to withstand such a period without the requirement to make a dilutive rights issue to raise capital in part because there it does not have much net debt today.

Furthermore, we learned the fly-by-hour contracts are subject to minimum spend levels which appear to be close to the expected numbers which are built into the original contracts putting a floor on the level of decline as a result of reduced flying hours.

We believe there are significant opportunities for the company to improve cash flow generation through better management of working capital and improved operational efficiency.  The company openly admits its inventory turns of ~3x need to improve to closer match those of competitors which average ~6x.  Each half turn improvement in inventory turns should throw off ~£400m of cash which could be returned to investors or reinvested in the business.  To take a conservative approach we have not included this factor in our valuation however it is an operational metric we will continue to monitor both as a way to measure management’s ability to execute on stated goals and also a potential upside to valuation.

6.    Capital allocation

Shareholders have been concerned by the company’s willingness to invest capital into its non-aerospace businesses, in which it has weaker competitive positions under spurious claims of cross division synergies.  We feel more comfortable about this risk because of the arrival of a new CEO Warren East in July 2015.  A review of Mr East’s tenure when he was CEO of ARM Holdings from 2001 to 2013 suggests he has ‘value’ mind-set when it comes to capital allocation.  For example, analysis of ARM Holdings’ share buybacks shows a clear pattern of the firm buying back shares when the share price was trading at its lowest multiples to free cash flow.  Furthermore, the recent emergence of value focused activist fund ValueAct Capital as the company’s second largest shareholder with a 10% stake should put further pressure on the company to act more rationally in its use of capital.

7.    Regulatory concerns

The European Commission has opened a preliminary investigation into potential anti-competitive practices in the bundling together of engine and aftermarket services. 

We believe the regulatory risk for Rolls Royce is low.  Although the market may not be very competitive it would be a near impossibility for the EU to remedy this.  They would be unable to mandate that engines should be sold unbundled from planes for example in the way they forced Microsoft to unbundle its browser from Windows.  We think the fundamental question is rather whether the existence of Airbus gives choice to airlines, which it was set-up to do.  The commission could in theory try to stop joint ventures between engine companies as these do reduce competition in a somewhat artificial way.  This would be positive for Rolls Royce since it acts the most independently of all its competitors.

Valuing Rolls Royce

We attended the Investor Day, which was held in November.  The event was about double the size of any similar event we have attended.   The Q&A was lengthy and at the end the CEO and CFO were mobbed by analysts.  It was clear that the analyst community were totally confused by the numbers.  There is no doubt that Rolls Royce accounting makes this a business which is challenging to understand and value.  The main question is determining the cash margins being earned on the MRO business vs the losses, they take on the new engine sales.  

From discussions with the company itself, its competitors, other industry participants, plus reading around the subject, we were able to build up a model, which appeared to back-test quite successfully.  This enabled us to apply conservative assumptions to their current installed base, order book and future share of new engines to build up a cashflow model for the aerospace business.   We added the power systems, marine and nuclear businesses – on a no growth basis - to build to an intrinsic value which implied we can buy at £7/share or lower with a significant margin of safety.  

To try to explain this model here in detail would be challenging.  A simple way to think about the value of Rolls Royce today is to consider a hypothetical case where Rolls Royce elects to stop growing its capacity and just fulfil to a reduced order book which keeps revenue stationary; on this basis, we believe we buy the business on a EV: free cashflow multiple of c.10x.  This assumes the power and marine businesses remain at their current cyclical low points.   We would be comfortable buying Rolls Royce on a 10% free cashflow yield, however what makes Rolls Royce compelling is that its current order book implies the installed base of engines on which it will collect MRO revenue will increase by over 80% in the next 8-10 years. 

We do not view Rolls Royce as a truly great business because of its scale disadvantage versus General Electric.  However the ‘margin of safety’ generated by the cash which its current installed base of engines, which are effectively immune from competition, will throw off provides the level of certainty we seek for investments in our portfolio.  Our long-term horizon allows us to take advantage of a market mispricing as we are able look past short-term issues which we believe analysis suggests are not structural in nature.

Catalyst

The company will start to generate significant cash-flow once it begins earning attractive positive cash margins on MRO work tied to an installed base of engines that are currently in the early 'ramp up' stage of their lifecycle such as thew Trent XWB and Trent 7000