Rolls-Royce Has No Margin for Error in Fixing Engine Problems

 |  Includes: GE, RYCEY, UTX
by: Alacra Pulse Check Blog
By Angus Robertson

The FT’s Lex is OK with Rolls-Royce Group’s (OTCPK:RYCEY) low-key response to the recent problems with its engines on Airbus A380s and a Boeing 747. But a scan of analyst comments on Alacra Pulse suggests the stakes are high for the company.

Qantas’s six A380 superjumbos have been grounded since Thursday, when a Rolls-Royce engine partly disintegrated mid-flight. Investigations have focused on oil leaks inside the Rolls-Royce Trent 900 engines, the same model used to power Singapore Airlines’ and German Lufthansa’s A380 fleet. And Wednesday Singapore Airlines said it will replace engines on three of its Airbus A380 planes after finding oil stains on them.

Noting that its customers are airlines, not passengers, Lex suggests that the engine-maker’s exposure to a BP or Toyota (NYSE:TM) style meltdown is limited.

Taking a different tack is Robert Cole at Reuters Breakingviews, who argues that Rolls-Royce’s reputation is most of its value: “…the airline industry is fragile, and only works because its customers have faith in the abilities of aero-engineers, and those that fly and maintain aircraft. If those abilities are questioned, the value—and values—of those implicated are shaken.”

Credit Agricole analyst Antoine Boivin-Champeaux shares that view: “Rolls’ reputation has been hit leading airlines to favor alternative engines when possible.”

Problems with Rolls engines open the door for rivals GE (NYSE:GE) and Pratt & Whitney, part of United Technologies (NYSE:UTX).

“Things move slowly in the engine business, but there is no question that you have a series of events that really put Rolls-Royce’s reputation at risk,” Richard Aboulafia, vice president at aviation consultancy Teal Group told Reuters. “Unless they can get ahead of this and prove that they can solve their many challenges, you can see an opportunity for Pratt to get back to No. 2 (ahead of Rolls).”

A GE-Pratt joint venture, the Engine Alliance, makes the other engine used on the A380.

MarketWatch reports that Rolls may face additional delays in its Boeing 787 and Airbus A350-XWB engine-development programs if the cause behind the A380 mishap turns out to be significant. “Some analysts worry Rolls-Royce has stretched itself too thin, that it has taken on too many projects, and that the current crisis may force the company to divert resources from of some of its development programs.”

Joseph Nadol, an aerospace analyst at JPMorgan, noted in September following a blowout of a test engine that Boeing could see the biggest risk to the development of its 787 Dreamliner jet coming from engines supplied by Rolls-Royce.

Avi Hodde at UBS is less concerned:”A bigger issue is whether Rolls’ reputation becomes viewed less favorably by airlines…Thousands of Rolls engines in service means this is unlikely in our view.”

Prior to the recent incidents Rupinder Vig ‘sMorgan Stanley lifted his recommendation on Rolls from Equal-weight to Overweight, and the target price from 580p to 720p. “We believe the market is missing the potential for improved profitability following the recovery in after-market revenues, progress in new programmes and the developed world replacement cycle kicking in.”

Rolls-Royce shares have doubled over the last 18 months to around 600p and trade at a premium to many peers, Breakingviews notes.

The battle to supply airplane engines is fierce, with deals being won or lost on the smallest of margins. Rolls-Royce has no margin for error in handling its engine problems, or it risks losing much more than just the A380 market.