Is It Time To Ditch Rolls-Royce After Six Difficult Years?

Rolls-Royce (LON:RR) shares are about 20% below where they were in 2013.

That’s very different to the previous six years (from 2007 to 2013) when the company’s shares went up by more than 150%.

So does this long period of weak share price performance mean Rolls-Royce is now a bargain, or is it simply a reflection of a struggling company?

Summary:

• Rolls-Royce primarily designs, builds and maintains engines and power systems for aerospace, naval and industrial markets
• It’s had a tough time in recent years with volatile and declining earnings
• Profitability is low while capital intensity and debts are high
• I’m not a huge fan and think the company should probably be split up

I’ll start off with a brief review of what the company does and then dive into its headline results over the past decade.

Rolls-Royce: A diverse power solutions business

Rolls-Royce’s goal is “to be the world’s leading industrial technology company”, which is a pretty broad remit.

In practice the company is mostly focused on the design, manufacture and maintenance of engines, primarily for aircraft.

Rolls-Royce splits its activities into three core areas and one recently acquired business unit:

• Core business units:
  • Civil Aviation: £7.4bn revenues
    • Engines for large commercial airliners, regional jets and business aviation
  • Power Systems: £3.9bn revenues
    • Primarily diesel engines and generators for marine, defence, utility and industrial applications
  • Defence: £3.1bn revenues
    • Engines for military aircraft, naval ships and maintenance of nuclear submarine power plants
• ITP Aero: £0.8bn revenues
  • Design, manufacture and maintenance of aerospace engines

At first glance this seems to be a bit of a sprawling mess, with operations spanning from nuclear power plant maintenance to diesel generators and jet engines.

Looking at Rolls-Royce’s 2018 annual report, management seem to agree and the company is currently undergoing a transformation programme.

Its commercial marine business is up for sale and the remaining core business units are being refocused into more autonomous businesses with simpler management structures and clearer lines of accountability.

I’m all in favour of focus, accountability, empowerment, agility and efficiency, so this is a step in the right direction as long as the changes go beyond the liberal use of buzzwords.

As for the future, the company has a three-phase plan for long-term success:

Rolls-Royce’s three-phase plan

1) Vitalise the core

Rolls-Royce wants to focus on what it does best by investing in and improving its three existing core businesses.

I think most companies can benefit from increasing their focus on a narrow core business, so this gets a thumbs up from me.

2) Champion electrification

This means investing in new power solutions for long-term success beyond hydrocarbons.

This makes a lot of sense as climate change and carbon emission limits are likely to undermine the long-term future of diesel engines, jet engines and gas turbines.

Electric and hybrid power systems are currently a minor part of Rolls-Royce’s business, but the decline of fossil fuel-powered aircraft, vehicles and grids is likely to take many decades, so the company has a lot of time to make the shift.

3) Transform the business

Rolls-Royce is seeking to act as a disruptor of markets affected by the electrification and digitalisation of power systems.

This is a nice idea but is impossible to quantify as none of this is happening with any sort of meaningful scale at the moment.

So that’s the 10,000 foot view of Rolls-Royce. Let’s get into a bit more detail by looking at Rolls-Royce’s financial results.

Growth is somewhat lacking

Here are the company’s results for the last ten years.

Rolls-Royce has produced a mixed bag of results

Picking that apart:

• Revenues:
  • Increased by about 40% over the period, or 5.1% annualised
  • Growth was fairly steady with revenues increasing seven times
• Earnings:
  • Very volatile with wild swings from minus £4 billion to plus £3.4 billion
  • Three years of losses in the last five years
  • Overall the trend was down, with the company recording a net loss over the last five years
• Capital employed:
  • The company’s base of fixed and working capital expanded by about 8% over the period, or 1.5% annualised.
  • Growth was steady until 2016, where losses led to reduced retained earnings and therefore reduced capital within the business
• Dividends:
  • Rolls-Royce’s dividend was progressing steadily until 2015, at which point it was cut by 50%
  • The dividend has remained unchanged since that cut
• Overall:
  • The company’s ten-year Growth Rate is 0.6% annualised (my preferred minimum is inflation, i.e. 2%)
  • The company’s Growth Quality is 59.5% (my preferred minimum is 75%)

In summary, revenues have consistently gone up, but the overall results are less than impressive. To a large extent this is down to the collapse of earnings in recent years, so let’s start there.

Earnings are volatile and occasionally negative

The first notable feature of Rolls-Royce’s earnings is they’re extreme volatility.

Fortunately this turns out to be an annoying but largely irrelevant feature of Rolls-Royce’s business. That’s because the volatility is mostly caused by currency hedging.

Currency hedging is basically a way for Rolls-Royce to reduce the risk of exchange rate fluctuations, primarily between US dollars (in which most of its revenues are paid) and pounds (in which most of its expenses are paid).

While currency hedging allows Rolls-Royce to run its business more effectively and with less risk, the currency hedging shows up on the income statement as non-cash gains and losses which are large enough to obscure the company’s underlying performance.

To help shareholders understand how the business is performing, Rolls-Royce publishes adjusted earnings figures. These remove the annoying hedging gains and losses, allowing us a much clearer view of the company’s actual operating results.

Less volatility but still a substantial earnings decline

The company’s adjusted earnings figures are far less volatile than the reported earnings, which is good.

What’s not so good (and is typical of adjusted earnings) is that they are overly optimistic when the company runs into serious trouble. You can see this most clearly in 2015 when adjusted earnings only declined very slightly but at the same time the dividend was cut in half.

What’s also not so good is that adjusted earnings still collapse after 2015.

So if the collapse in earnings wasn’t caused by irrelevant currency fluctuations, what was it caused by? Let’s break it down by year:

2015: Weaker markets and a new CEO

2015’s adjusted earnings only declined by a very small amount.

This was due to weaker aerospace and marine markets, with offshore marine markets being affected by declining oil and gas prices (lower oil and gas prices means less offshore activity which means less sales and maintenance revenue for Rolls-Royce).

An incumbent CEO would, I suspect, have held the dividend during this period of weaker demand and tried to muddle through without an aggressive restructuring plan.

But as luck (or not) would have it, the company had very recently switched to a new CEO and, as new CEOs often do, this one was more than happy to announce a sweeping “transformation” program. Unfortunately for investors, this transformation would require much cash investment, hence the 50% dividend cut.

As for the transformation plan, it sounded reasonable enough: Simplify the company and strip out costs to make it more efficient, agile, accountable and transparent.

2016: Corruption, weak aerospace and marine losses

Unlike the modest decline of 2015, adjusted earnings in 2016 fell by around 50%.

However, this adjusted amount didn’t include a £671m fine paid by Rolls-Royce. The fine came after a Serious Fraud Office investigation into Rolls-Royce’s activities in China, India and other markets over more than 20 years.

So corruption didn’t affect adjusted earnings, but continued weakness in aerospace markets and losses from the offshore marine business did.

The dividend was held at its new 50% lower level.

2017: Stronger markets and in-service engine issues

In 2017 Rolls-Royce faced slightly improved markets, but there were also significant in-service issues with some of its engines. These could potentially increase maintenance costs and customer disruption for years to come.

More fundamentally, the transformation program intensified and the company began to look at offloading its struggling offshore marine business.

The dividend was held at its 50% lower level for a second year.

2018: Further significant costs relating to engine issues

According to Rolls-Royce’s CEO, the company made impressive progress in its transformation into a more simple, agile, efficient and transparent company. In the short-term though, this progress was largely offset by continuing in-service issues with engines, which caused “significant disruption for a number of our customers“.

These engine issues highlight some of the problems with long-term maintenance contracts.

Yes, they’re a nice source of returns for years and possibly decades, but with those returns also comes risk. The risk is that the cost of providing maintenance is higher than expected, and that could generate losses on certain contracts for years to come.

No clear pattern of progress and much uncertainty

Whether you look at Rolls-Royce’s reported or adjusted earnings, the story is much the same.

The company has had a very difficult time over the last few years. This no doubt came as a shock to investors in 2014 who were buying Rolls-Royce shares for 1200p and more (compared to a price of 910p today, some five years later).

Personally I’m not a huge fan of investing in turnarounds and transformations. The uncertainties are huge and in many cases the transformation fails.

My gut feeling is that permanent decline isn’t the most likely outcome for Rolls-Royce. The company appears to have many competitive strengths, such as scale, deep technical capabilities and long relationships with major customers.

But appearances can be deceiving, so let’s have a look at Rolls-Royce’s profitability, which I think is one of the best concrete measures of competitive advantage.

Profitability is sub-par or okay at best

Volatile returns leading to weak profitability

I measure profitability using net return on sales (net profit margin) and net return on capital employed.

Using Rolls-Royce’s reported earnings (because I’m not a fan of adjusted earnings as they’re the business equivalent of asking a child to mark their own homework) the company has the following results:

• 10-Year average net return on sales = 3.1% (my minimum is 5%)
• 10-Year average net return on capital = 6.1% (my minimum is 10%)

These are the results of a company with no meaningful ability to raise prices above those of its competition, nor any ability to provide products or services at a lower cost than its competition.

In other words, these are the results of a company with no meaningful durable competitive advantages.

This doesn’t mean Rolls-Royce can’t compete and win business, but it does suggest that the company has to accept below average profits in order to do so.

Okay, that sounds a bit negative, so let’s look at Rolls-Royce’s profitability using its more optimistic adjusted earnings:

• 10-Year average adjusted net return on sales = 6.5%
• 10-Year average adjusted net return on capital = 12.5%

Measuring adjusted returns raises Rolls-Royce’s profitability from sub-standard to acceptable.

In reality though, I would still rather measure the company’s progress using reported earnings as they’re a more accurate representation of the company’s true progress over a number of years.

Rolls-Royce has net cash but debt levels are still high

Rolls-Royce’s cash and debt positions are a bit odd.

It has cash and cash equivalents (e.g. money in short-term deposit accounts or money-market funds) of almost £5 billion. That’s a lot, especially as the company’s ten-year average net profit comes in at a mere £0.4 billion.

Exactly why the company needs 12-times its annual profits held as cash in the bank is beyond me, but I’m sure there’s a sensible reason.

That giant cash pile more than offsets the company’s sizeable £4.5 billion mountain of unsecured debt.

My usual rule for debt is:

Debt ruleOnly invest in defensive companies when borrowings are less than five-times their ten-year average net profits

Rolls-Royce’s debts are a worrying 11-times the company’s average profits, so of course they’re way above where I’d prefer them to be. However, this isn’t a complete surprise.

Companies that require lots of expensive assets to run (such as factories, manufacturing equipment, etc.) and which get relatively weak returns on those assets (6.1% in this case) often don’t generate enough cash to be able to upgrade and expand their assets. So they use borrowed money instead.

Another trait of capital-intensive businesses is that they have large capital expenses, and that seems to be the case with Rolls-Royce too.

Capital intensity is high, which is both good and bad

Capital expenses are steadily increasing

Rolls-Royce needs lots of buildings and machinery and equipment to design, build and maintain engines and power systems for customers.

None of these come cheap, and in the last decade Rolls-Royce spent approximately £10 billion on capital expenses, i.e. maintaining and expanding its capital assets.

That’s a lot given that the company’s total ten-year profits only amounted to a little over £4 billion.

I have a rule for capex which is:

Capex ruleBe wary of companies that consistently spend more on capital expenses than they make in profit

With a ten-year capex to profit ratio of 240%, it’s safe to say that Rolls-Royce is a very capital intensive business.

On the positive side, the need for billion of pounds of capital assets acts as a barrier to entry, so unlike Facebook (NASDAQ:FB), Rolls-Royce doesn’t have to worry about millions of kids in garages trying to come up with the next big thing.

Without billions of pounds invested in fixed assets, garage startups are just not going to compete with a company like Rolls-Royce.

On the negative side, capital intensive companies usually find it harder to grow, simply because they need to invest heavily in capital assets today in order to generate more profits tomorrow.

And if existing assets produce weak returns on capital (as they often do), the company is likely to fund its capital asset expansion using debt, which seems to be what Rolls-Royce has done.

This combination of high capital intensity, mediocre returns on capital and high levels of debt is the opposite of what I look for in a company.

Because of that, if I was going to buy Rolls-Royce the price would need to be extremely low to offset the company’s negative features.

Fair value for Rolls-Royce

Rolls-Royce share are currently trading at 910p and the FTSE 100 is at 7430.

At that price the company has a:

• dividend yield of 1.3% (FTSE 100 = 4.3%)
• PE10 (price to ten-year average earnings) ratio of 41 (FTSE 100 = 17.4)
• PD10 (price to ten-year average dividend) ratio of 55.3 (FTSE 100 = 31.7)

As you can see, Rolls-Royce has a much lower dividend yield and much higher price relative to historic earnings and dividends compared to the market average.

This is not good.

The FTSE 100 has produced far steadier earnings and dividend growth than Rolls-Royce over the last decade, and it’s also trading on a significantly lower valuation.

For example, if Rolls-Royce doubled its dividend tomorrow, back to where it was in 2014 when the company was riding high after years of steady growth, its shares would still only have a dividend yield of 2.5%.

That means the market must be expecting Rolls-Royce to recover from its current problems quickly and then to move onto consistent, above average growth for years (possibly decades) to come.

That’s certainly one possible future, but it seems a little optimistic to me.

Personally, given the company’s unimpressive performance over the last decade, I would only consider investing if the share price was much, much lower than it is today.

How much lower?

Well, Rolls-Royce currently sits at the very bottom of my stock screen in position 186 out of 186 FTSE All-Share dividend-payers. That’s not a good start.

According to that stock screen, for Rolls-Royce to be even remotely attractive its share price would have to fall below 400p.

At that price it would have a dividend yield today of 2.9%, which is still pretty weak, but if the company could return the dividend to its former level then at least it would have a yield of 5.8%.

I think that’s a more reasonable reflection of the uncertainties which clearly exist around Rolls-Royce and its future.

And even at 400p the company has many features which I do not like.

Rolls-Royce: I like the cars* but not the company

Overall then, I’m afraid Rolls-Royce isn’t for me.

Yes, it may be a market leader in growing markets and have long-term annuity-like maintenance contracts with major customers, but it also has a lot of things I don’t like:

• It’s had a very choppy ride these past few years with volatile and occasionally negative earnings
• The dividend was cut a few years ago and has remained 50% below its peak
• Returns on sales and capital employed are either weak (using reported earnings) or ho-hum (using adjusted earnings), imply that the company has little or no durable competitive advantage
• Debt levels are high
• Capital intensity is high as Rolls-Royce must invest in expensive capital assets to manufacture its engines and power systems
• Despite all this, the company’s share price is only 25% below its all-time peak, suggesting that investors are still optimistic about its future

This mix of fairly negative features is why Rolls-Royce sits at the very bottom of my stock screen.

That may or may not be a fair reflection of the quality of Rolls-Royce as a company, but it does reflect the fact that Rolls-Royce doesn’t really fit my preference for companies that are:

• Producing consistent growth, ahead of inflation, across a broad range of metrics (revenues, earnings, capital employed, dividends)
• More profitable than average, in terms of both return on sales and return on capital employed
• Less indebted than average
• Not very capital intensive, and when they are they should have less risk from other factor

Perhaps Rolls-Royce should be broken up

I’d like to make one final point which is that in my experience the best way to produce results is to be laser focused on whatever it is you do best.

That’s true of companies as well as people and we’ve seen examples of this recently in some large high profile firms:

• GlaxoSmithKline has decided to split into two companies; one focused on over the counter consumer healthcare products and one focused on pharmaceuticals and vaccines.
• Reckitt Benckiser is doing something similar by splitting itself internally into two separate businesses, one focused on health products and one on home hygiene products.

I think these are positive moves by these companies and perhaps Rolls-Royce should do something similar. The most obvious move would be to separate out relatively unrelated businesses like nuclear plant maintenance, aerospace engines and utility-scale diesel generators.

To me that makes a lot of sense, but I won’t be holding my breath.

* Yes, I know that Rolls-Royce PLC doesn’t make cars

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