Summary
- Rolls Royce Holdings plc (OTC:RYCEY) is a global engine and power systems business with market-leading positions in several markets
- After four profit warnings in the last 18 months, investors are cautious and the shares have fallen by around 40%
- The company expects its current problems to be resolved in the medium-term and longer-term still expects significant growth
- My “fair value” estimate is 35% above the current price of 780p, but the company’s massive pension scheme could pose a significant risk
Investment checklist
This analysis is based on an investment checklist of 28 questions which I use to help me decide:
- If the company has any competitive advantages
- If its shares are “good”, “fair” or “poor” value
- Whether it’s a potential value trap
Management
1. Does the company have a clear and consistent goal and strategy?
YES – The company’s current long-term goal is to provide the world with more efficient power systems that can help in the battle against climate change.
It’s long-term strategy for achieving that goal is to design, develop, manufacture and service engines and integrated power systems for use in the air, on land and at sea. From the latest annual report:
We are one of the world’s leading producers of aero engines for large civil aircraft and corporate jets. We are the second largest provider of defence aero engines and services in the world. For land and sea markets, reciprocating engines and systems from Rolls-Royce are in marine, distributed energy, oil & gas, rail and off-highway vehicle applications. In nuclear, we have a strong instrumentation, product and service capability in both civil power and submarine propulsion.
This long-term strategy has focused on the same 5 key elements over the last 20 years:
- Address four global markets: Civil and defence aerospace, marine and energy.
- Invest in technology, infrastructure and capability: Invest significantly in research and development, training and large capital projects.
- Develop a competitive portfolio of products and services: Rolls-Royce has more than 50 current product programmes and is involved in many future projects which will help to define the power systems market in the years ahead.
- Grow market share and installed product base: Engines already in service are expected to generate attractive returns over many decades.
- Add value for our customers through the provision of product-related services: Providing aftermarket services that will enhance product performance and reliability.
In the medium-term Rolls-Royce is focused on addressing the challenges which have caused the 40% decline in its share price (which I’ll cover in more detail later on). Its medium-term focus is on the “4Cs”, which are:
- Customer: Improve quality, delivery, reliability and responsiveness.
- Concentration: Decide where to invest and where not to. E.g. acquiring Daimler’s 50% shareholding in Rolls-Royce Power Systems for £1.94 billion, or completing the sale of the energy gas turbines and compressor business to Siemens.
- Cost: Take action to improve cost performance in every part of the business and in every cost category.
- Cash: Focus on improving free cash flow in the face of multiple near-term headwinds.
2. Does the company have an obvious core business?
YES – Its core business is the design, development, manufacture and service of engines and integrated power systems for use on land, sea and in the air.
Financial performance
The financial ratios below are taken from this free investment spreadsheet.
3. Does the company have an above average record of growth?
YES – The chart below shows Rolls-Royce’s financial performance in terms of revenues, normalised earnings and dividends over the last few years:
During that period the company had a:
- Growth Rate of 9% per year, compared to 0.8% for the FTSE 100
- Growth Quality (i.e. consistency) of 83%, compared to 50% for the FTSE 100
So in terms of growth, Rolls-Royce has grown more quickly and more consistently than the large-cap market overall.
4. Is the company more profitable than average?
NO – Rolls-Royce is not an especially profitable company relative to the amount of assets required to produce those profits. Specifically, it has:
- Average Net ROCE (10-year median post-tax returns on capital employed) of 8.7%, compared to around 10% for the FTSE 100
5. Does the company have conservative financial obligations?
NO – There are two key financial obligations that I track: total interest bearing debts (borrowings) and defined benefit pension obligations.
If either of these is “too large” it can result in dividend cuts and rights issues as the interests of lenders and pensioners come before those of shareholders.
Rolls-Royce has borrowings of £3.2bn compared to 5-year average post-tax profits of £1bn, which gives it a:
- Debt Ratio (ratio of borrowings to 5-year average post-tax profits) of 3.2
The company operates in the defensive Aerospace & Defence sector and for defensive companies my Debt Ratio limit is 5, so Rolls-Royce is comfortably below that limit.
It also has defined benefit pension obligations of £12.4bn, which means it has a:
- Pension Ratio (ratio of pension obligations to 5-year average post-tax profits) of 12.3
I have a couple of rules of thumb which say:
- Don’t invest in a company if its Pension Ratio is more than 10
- Don’t invest in a company if the sum of its Pension and Debt Ratios is more than 10
Clearly Rolls-Royce’s pension scheme causes it to violate both of those rules of thumb. If its obligations continue to expand (they have grown from £6.5bn in 2008 to £12.4bn today) then the risks of a massive pension deficit are, in my opinion, too high.
On a positive note, the company has at least purchased “longevity swaps”, which insure it against the cost of its retired employees living longer than expected. However, those swaps only cover £3bn of the total obligation, leaving £9bn uninsured.
One other plus point is that the defined benefit scheme was closed to new members in 2007.
As a result of its massive pension obligation and deficit risk, Rolls-Royce will be excluded from my buy list until those obligations are reduced or until the company’s profits are significantly increased.
6. At the current share price, are its valuation ratios better than the market average?
NO – Rolls-Royce’s share price has fallen by around 40% from its previous highs, but it is still not cheaper than the market average. With its shares at 780p and the FTSE 100 at 6,800, Rolls-Royce has a:
- PE10 ratio (ratio of price to 10-year average earnings) of 15.9, compared to 14.3 for the FTSE 100
- PD10 ratio (ratio of price to 10-year average dividend) of 46.1, compared to 33.5 for the FTSE 100
- Dividend yield of 3.0%, compared to 3.4% for the FTSE 100
So despite its current problems, investors must still be expecting Rolls-Royce to grow its dividend faster than the market average over the medium to longer-term, otherwise they would not accept the lower dividend yield and weaker valuation ratios.
Financial control
7. Do the company’s Key Performance Indicators (KPIs) focus on relevant factors beyond revenue and EPS growth, such as profitability, leverage, liquidity and investment?
YES – The company’s KPIs include research and development expenditure, capital expenditure (i.e. investment), cash/debt ratio (liquidity and leverage) and free cash flow (liquidity and profitability).
Low costs
8. Is the company in the leading group in terms of market share within its chosen markets (economies of scale)?
YES – Rolls-Royce is the second largest provider of defence aero engines and services in the world and the leading provider of engines for military transport aircraft and business jets. It also has strong positions in many of its other markets.
9. Has the company had the same core business for many years (economies of experience)?
YES – Although Rolls-Royce started off manufacturing cars in 1906, it has been designing and manufacturing aircraft engines for the military since the start of the First World War in 1914. It moved into civil aviation shortly after the end of the Second World War.
Big projects
10. Is the company free of “bold” projects which, if they failed, could push it into a major crisis?
YES – Rolls-Royce had a difficult year in 2014 and as a result has embarked on “decisive action [which] is driving a transformation of the business”.
This transformation is currently focused on improving the 4Cs mentioned earlier: Customer, Concentration, Cost and Cash.
This is a company-wide effort but it appears to me to be evolutionary rather than revolutionary, and does not fit into the category of what I would consider high risk “bet the company” projects.
11. Is the company free of the need for large capital expenditures (capex)?
YES – Although my answer is yes, Rolls-Royce does spend huge sums on capital expenses. For example, over the past 10 capex has averaged just over £750m per year.
This need for significant capital expenditure is due to the nature of its business, which involves many years of research and development before new engines or other technologies can be put into production, and that production then requires expensive factories and equipment.
However, £750m is still less than the company’s average post-tax profit over the same period, which came to just over £1bn. This means that Rolls-Royce has an:
- Average Capex Ratio (ratio of capex to post-tax profits) of 70%
That is above average, but slightly below my definition of “high average capex”, which is anything over 100%.
12. Are revenues generated through the sale of a large number of small-ticket items rather than through major one-off contracts?
NO – Rather than selling engines one at a time, Rolls-Royce signs large contracts, sometimes valued in billions of pounds, to supply and service multiple engines and power systems over many years.
Its largest contract to date has a value of some £6bn, and covers the supply and service of engines for the Emirates airline’s fleet of Airbus A380 “double decker” commercial airliners.
The company’s order book is currently valued at £74bn, so that large Emirates contract on its own makes up approximately 8% of the order book.
Although this is a significant reliance on a single contract, I don’t think the company is over-exposed to these large contracts. I don’t yet have a rule of thumb on when a contract is “too big”, but if I did I think it would be higher than 8% of the order book.
Mergers and acquisitions
13. Has the company avoided mergers or large acquisitions in the last few years (i.e. cost more than a year’s profit)?
NO – In 2011 Rolls-Royce spent approximately £1.5bn purchasing Tognum, a German industrial engines group, alongside Daimler in a 50/50 joint venture acquisition. This was a “large” acquisition as it came to more than 100% of that year’s post-tax profits (which is my definition of large).
In 2014 the company purchased the remaining 50% of what was Tognum (now part of its Power Systems business) for £1.9bn. This is also classified as a “large” acquisition, costing more than 150% of that year’s post-tax profits.
This large acquisition does not appear to have destabilised Rolls-Royce and its integration appears to have gone smoothly.
On average, acquisitions for Rolls-Royce have equalled 40% of post-tax profits over the last 10 years, which is not particularly high.
14. Has the company avoided acquisitions that have little to do with its core capability?
YES – The only large acquisition (Tognum) is closely related to the company’s core engines business.
Changing markets
15. Does the company operate in defensive markets?
YES – The company is in the Aerospace & Defense sector, which is a defensive sector. However, Rolls-Royce’s largest market, civil aviation, is cyclical.
In recent years the company has been trying to diversify away from civil aviation in order to reduce this cyclicality. For example, in 2008 49% of total revenues came from civil aviation; by 2014 that percentage had dropped to 47%, which is not a massive difference.
Another way in which Rolls-Royce has tried to reduce its cyclicality is through long-term service contracts, which produce more reliable revenues and profits than the sale of new engines (called “original equipment”).
As less than half of total revenues come from the cyclical civil aviation sector and about half of total revenues come from the more defensive service side of the business, I would say it is reasonable to call Rolls-Royce a defensive company.
16. Does the company operate in markets where the pattern of demand (whether cyclical or defensive) is expected to stay the same?
YES – I see no obvious evidence that the pattern of demand will change significantly in the short or medium-term.
17. Does the company operate in markets where demand is expected to grow?
YES – Rolls-Royce expects all of its major markets (civil and defensive aerospace, power systems, marine and nuclear) to grow over the next 20 years. I think that expectation is reasonable.
Products and services
18. Does the company generate most of its profits from products or contracts that do not need to be replaced in the next 10 years?
YES – Although the company’s engine and power system products do need to be regularly replaced with newer, better versions, this regularity is actually quite slow.
Many of the company’s product designs have a useful life of more than 20 years or more, with the help of interim upgrades and other improvements which do not involve a complete redesign.
19. Does the company sell differentiated products that do not compete purely on price?
YES – Through the use of patents and long, expensive development phases, many of Rolls-Royce’s products are best in class at their respective jobs. Although it is not impossible for other companies to produce better products, the difficulty of this task means its engines and other products often do not compete purely on price.
This “hard to replicate” argument is taken even further when the company’s TotalCare service package is included, where Rolls-Royce has a lot of experience of providing product-related services which involve a tightly integrated and complex relationship with its customers.
Commodity prices
20. Is the company relatively immune to commodity price movements?
YES – Although commodities are used as inputs for its products and many of its customers are affected to a large degree by commodity price movements, they do not have a significant impact on Rolls-Royce.
Financial goals
21. Does the company have an expected rate of return on investment (ROCE or similar) of more than 10%?
NO – Although the company does focus on return on sales (11.5% in 2014) it does not have a measure for return on capital or return on investment. This is very probably tracked within the business, but it is not obviously a major focus of the company, which it should be.
Competitive advantages
22. Does the company have any intangible asset advantages (e.g. brand names that command pricing power; patents; regulatory barriers)?
YES – The company has two main intangible assets: its brand name and its collection of patents.
Rolls-Royce is known throughout the world for its engines and engineering capabilities and this brand familiarity enormously increases the likelihood that the company’s products will be seriously considered by its target audience. A much less well-known company would have a considerably bigger “credibility gap” to overcome.
Its patents are also an intangible asset. For example, in 2014 the company spent some £1.2bn on research and development, producing 600 patents along the way. In principle these patents give the company a monopoly on a particular technical solution which can make the patent-protected products hard to compete against.
23. Does the company gain an advantage from the effort required for customers to switch to another supplier (e.g. bank accounts or computer software)?
YES – If an airline decided to use Rolls-Royce engines in a fleet of aircraft, and to have Rolls-Royce provide complex, tightly integrated services to support those engines during their lifetime, both companies would work to optimise related technical solutions and processes.
Because of this I expect it would be much easier for this airline to continue to use Rolls-Royce for a different fleet of aircraft, or to use new Rolls-Royce engines when it is time to replace the old Rolls-Royce engines (whether for the same aircraft or new ones).
This creates a barrier between that customer and other engine suppliers, although how high that barrier is I do not know.
The flip-side of this is that Rolls-Royce’s major competitors could also benefit from this same competitive advantage.
24. Does the company have a network effect, i.e. becomes more attractive as more people use its services (e.g. Facebook (NASDAQ:FB), eBay)?
NO – The company’s products or services do not become appreciably better just because more customers are using them.
25. Does the company have any durable cost advantages (e.g. unique location, unique low cost source of raw materials, greater scale)?
NO – I don’t see any obvious evidence that the company has a durable cost advantage over its major competitors.
Potential risks and rewards
26. At the current share price are the shares closest to my estimate of good, fair or poor value?
GOOD VALUE – At 780p Rolls-Royce has a rank of 63 out of 230 qualifying stocks on my stock screen, slightly outside the top 50 which represents my definition of “good value”.
My current “good”, “fair” and “poor” value prices for Rolls-Royce are:
- Good value (top 50 rank): 700p (10% below the current price)
- Fair value (average rank): 1,050p (35% above the current price)
- Poor value (bottom 50 rank): 1,550p (99% above the current price)
I would seriously consider buying the shares at anything below the “good value” price (ignoring for now its large pension scheme).
At 700p the shares would have a dividend yield of 3.3%, more or less in line with the FTSE 100’s current yield, but from a company with an above average record of growth and perhaps greater dividend growth potential over the medium to longer-term.
At the “fair value” price of 1,050p the shares would yield 2.2% and this price is clearly achievable, given that the shares reached almost 1,300p at the start of 2014.
27. Are the odds of this company being a value trap acceptably low, and why?
NO – A value trap is when a company’s shares appear to be cheap, but turn out not to be because the company subsequently runs into major problems, cuts its dividend, announces a rights issue, or worse.
In the case of Rolls-Royce its shares do appear to be cheap, but I think there is a significant risk of a reduction in its ability to pay future dividends.
The company has issued four profit warnings in the last 18 months and its latest update, published in July, outlined its current problems and their implications for the future.
It describes its current “significant market pressures” as:
- Falling sales – For its Trent 700 engine as it introduces the newer Trent 7000 engine
- Weak demand – From the business jet engine market and aftermarket
- Weak demand – From offshore marine markets
One casualty of these headwinds is the share buyback scheme, which has been suspended some £500m short of its initial £1bn buyback target.
None of these issues are expected by the company to extend beyond the medium-term. Rolls-Royce still expects to see significant revenue growth over the next 10 years.
I see no obvious reason to doubt that opinion and so I don’t think the major risk to future dividend growth is its current operational problems.
I think the more significant problem is its massive pension obligations, which has the potential to amplify the effects of any operational weaknesses.
At more than 12-times average earnings, a 10% deficit would require more than £1bn of cash to be pumped into the scheme to return it to surplus.
The company would have little choice in the matter, as it is legally obliged to fully fund the scheme.
Although, as I have already mentioned, it has taken out “longevity swaps” and has also reduced the equity allocation of its pension assets to reduce volatility and risk, to me the scheme still represents a massive potential black hole.
Although I would like to invest in Rolls-Royce, I won’t be doing so until it gets that pension scheme under control.
That will only happen if it sells some of the obligations to a third party or if it can grow its earnings faster than the pension scheme grows its obligations.
28. Is the company’s use of leverage conservative enough given the likelihood of it being a value trap?
NO – Although Rolls-Royce has a Debt Ratio of 3.2, which is significantly below my limit of 5 for defensive companies, I would like to see that debt level reduced further to offset some of the risk from its pension scheme.
As I mentioned earlier, I have a rule of thumb which is to not invest in companies where the combined Debt and Pension Ratios are above 10 (currently it’s 15.5 largely because of the Pension Ratio of 12.3).
Reducing the level of debt would be a big help in reducing the risks associated with the company’s very significant pension obligations.