Rolls-Royce Holding PLC: Mind The Gap by Greenwood Investors
In the past month, we have built a new core position in Rolls-Royce. We have been uncharacteristically quiet as it relates to our latest core large-cap position, because we’ve been trying to influence the focus of the new CEO (who has an excellent track record) on operational issues. We’ve also been trying to build a groundswell of support for our operational plan amongst some large suggestivist investors – although not ValueAct oddly enough, as Ubben is one of our role models. Now that the horse is leaving the barn on the Rolls-Royce opportunity, and an earlier copy of our research has been posted elsewhere, we’re pleased to publicly post the research that we shared with investors earlier in the month.
Rolls-Royce is going through a perfect storm right now. It is rapidly growing its large engine installed base (it has the most fuel efficient large engines in the world), and it’s selling these engines at a loss. While Jeff Bezos would love this long-term investment prospect, nearly everyone else in the western world has run away. Only 18% of sell-side analysts still recommend buying shares of the company, and confusion is running very high – consensus operating income estimates for next year are for anywhere from £1 billion to £2 billion. You could fly an A350 through that spread, it’s so wide. Actually, if we stacked up the coins of one billion quid, the distance would be able to accommodate over 45,000 A350s simultaneously.
In our first research piece (with assuredly, many more to come), we have sought to engage in a discussion about the one factor that will make the biggest difference in our investment returns in Rolls-Royce: the deep margin gap its civil aerospace division has relative to GE. While a cyclical recovery in capital spending in the land & sea division (we’re not counting on it), could drive a fair amount of incremental upside (perhaps £1.00-2.00), it pales in comparison to the significant opportunity the company has if it were to emulate its American competitor and fix the margins on its engine sales. The financial metrics presented herein are a bullish scenario if the company were to enact the operational initiatives described. Until the company starts taking action, they will most certainly be wrong, and be too optimistic. Furthermore, we have continued to refine our model assumptions since this report was published, and will be publishing an updated set of financials in our next post. Our point was to show the significant difference that can be made if the new CEO uses his engineering background to fix the inefficiencies that lie in the supply chain. Thankfully, on his daily commute to work, he’ll be reminded to, “Mind the Gap.”
Rolls-Royce Holding PLC: Mind The Gap
In A Nutshell:
As a new CEO with a great track record just assumed the cockpit and predictably lowered near-term expectations, Rolls-Royce represents a very compelling investment, particularly for a new CEO that can craft a new flight path for restoring the company’s competitiveness back to a level compatible with its perceived brand awareness. The aerospace division of Rolls-Royce, which represents roughly two thirds of its revenue, is significantly under-earning its main competitor, GE Aviation, by over half. Rolls-Royce’s strategy of using outsourced third parties for 75% of the value of the jet engine has put the company at a significant disadvantage versus its American competitor. Yet, we view this entire margin gap as a very fixable situation. We have sought to lay out a playbook for the company to use that will allow it to profitably reap the benefits of significant investments it has made in the most fuel efficient engines in the world. The company’s installed base of wide-body engines will be growing at twice the rate of the fastest-growing segment of the commercial aerospace industry, which enjoys a very deep order book as the current fleet of aircraft is at its oldest age ever. Order books for key twin aisle aircraft stretch well into the 2020s, and Rolls-Royce exclusively powers the most efficient planes. We believe if Warren East can pull inefficiencies out of Rolls-Royce’ supply chain, he can add more than the entire market capitalization in incremental value. Thankfully, East will have a daily reminder on his commute to “Mind the Gap.”
Rolls-Royce is a manufacturer of high-quality engines, primarily for aircraft, but it also has a division that focuses on marine and terrestrial applications (the source of a recent controversial acquisition). Roughly two-thirds of the company’s revenues are generated by commercial and military aircraft engines, and these divisions are not only the most valuable parts of the business, but have the most robust growth trajectory, and also offer the largest opportunity for Rolls-Royce to improve its profitability. This will, in turn, lift the value investors are willing to pay for this business. Last week, the company replaced its under-performing CEO with the former CEO of ARM Holdings, Warren East. We believe the timing is perfect for East to restore Rolls-Royce back to being an international competitor worthy of the respect its brand name often receives. Currently, it’s the cheapest company competing in the commercial aerospace industry, yet it has one of the best trajectories for top line growth. The primary reason for this discount is the underwhelming nature of the company’s profit goals, which are currently half that of GE Aviation. We’ve built a very detailed roadmap for East to use as he prepares to assume the cockpit, which leverages his experience from ARM Holdings. An engineer with a very technical focus on operating businesses, East will need to in-source core capabilities of engine production, capitalize on the significant synergies which exist in its outsourced supply chain, and continue to repurchase shares while the valuation reflects very pessimistic prospects for the company. From our conversations with former ARM shareholders, these were the key characteristics of his outstanding management.
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