How long have you held the stock?
Since February 2014. Rolls-Royce, which is listed on the London Stock Exchange (RR:LSE), is down 25% from its highs after issuing a profit warning in February. We used this as an opportunity to take exposure.
What do you like about it?
We encounter few industrial businesses as high a quality as Rolls-Royce’s civil aviation business, the second-largest manufacturer of aircraft engines globally.
A combination of long-term servicing agreements, a 50% duopoly market in wide-body jets, and exposure to secular passenger growth, assist in continually driving above-average economic returns through the cycle.
(Note Rolls-Royce does not manufacture motor vehicles as the brand is now owned by BMW.)
How is it better than its competitors?
Rolls-Royce employs a unique sales model in its civil aviation business that differentiates it from its competitors, whereby 90% of its high-thrust engines are sold as part of a 10-15 year servicing agreement.
The beauty of this model is that it locks in the lucrative after-market parts business, which typically posts margins significantly higher than the original jet engine sale. This results in Rolls-Royce often servicing most of their own engines at a given airport (as opposed to the airline operator), which drives significant economies of scale.
What do you like about its management?
We like the fact that Rolls-Royce’s management is more interested in generating returns for shareholders, than outright growth. This is reflected in their recent decision to exit the narrow-body jet market, which, while a larger market, does not share the same duopoly market conditions that wide-body jets exhibit (and hence better returns).
What is your target price on Rolls-Royce?
We value Rolls-Royce at £12.70 a share, although we expect this valuation to grow over time as their installed fleet of engines grows. We apply a contrarian value approach to investing, and believe better investments are made when stocks are unpopular or out of favour.
When we analysed the reasons for the profit warning in February this year, the issues appear contained within their defence business, which is significantly smaller than their civil aviation business, and will get relatively smaller as the civil business grows.
In our view, it appears a classic case of the market over-penalising a stock for a small issue, and missing the longer-term attractions of the core operating business, civil aviation.
At what point would you sell it?
Should the stock approach our assessment of intrinsic value of £12.70 in the next 12 months, we would start to exit the stock. However, as we expect the Trent engine delivery programme to double in the next few years, and hence as these cash-flows become more certain over time, our exit price will likely increase alongside the growth in intrinsic value.
Is it a liquid stock?
The stock is highly liquid with a market cap of £20 billion.
Where do you see the value?
In many respects, the engine manufacturer on an aircraft is the sweet spot of the aeronautical economic food chain. Airlines are highly capital-intensive, competitive, and fortunate to make mid-single digit profit margins.
Aircraft manufacturers, such as Boeing and Airbus, also operate in a duopoly market, but do not require or enjoy the same levels of aftermarket service.
Rolls-Royce, however, is able to lock in this high-margin profit source on a multi-year basis.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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