Bullish investors claim that Rolls Royce (OTCPK:RYCEF) is only going through a transformation period and possesses billions of dollars' worth of intangible assets (R&D) that are overlooked. They also argue that its pre-tax profit grew a massive 138% from 2014 to 2015. However, upon closer inspection, RR's financial figures raise some serious questions. While its pre-tax profit more than doubled, its underlying profit dropped 13.2%. Its order book also increased 3.4% yet revenue remained roughly the same (slight decrease of £11M). Even with RR supposedly leading the "big three" aero-engine manufacturers because it powers 17 different aircrafts (compared to GE's (NYSE:GE) 14 and Pratt & Whitney's 10), over 60% of the firm's order book come solely from one engine product - the Trent XWB that is currently only used by Airbus A350. Airlines in Latin America, North America, and Europe are decreasing fleet capacity in response to pricing pressures, with such capacity cuts continuing through 2017. In order to soothe investor fears, RR will need to diversify its order book more evenly and address the growing aftermarket risks in its Civil Aerospace division.
Though RR continues to struggle in Civil Aerospace, it is expected to see strong growth in the Defense unit, particularly in European markets where Russian aggression and security uncertainty rises. According to industry overviews, EU countries such as France, Germany, U.K., Sweden, Poland, and Italy are expected to increase defense spending by 2 - 5% in the next few years. Meanwhile, defense contractors and investors are celebrating in the U.S. as president-elect Trump has promised to finance a more robust military. Though Bloomberg analysts predict that Trump's plan would add upwards of $80bn in increased defense spending, budgeting experts predict such drastic increases will be unlikely to happen. Nonetheless, the S&P Aerospace & Defense index shot up 3.9% on Wednesday following the election and climbed an additional 2% the following day, outperforming the 500 index by the biggest margin since 1989.
Meanwhile, the Land & Sea arenas are expected to drop in the short term. Nuclear plant demands have yet to recover from the Fukushima accident in 2011. Whereas, the marine market has shown weak order trends over the past 3 years from the price pressures of shipyard overcapacity.
Though I believe RR to be overvalued from its lackluster profitability and upcoming challenges in its individual divisions, its intangible assets should not be overlooked. Large investments in R&D help provide a structural competitive advantage in wide-body aircraft. Even with growing headwinds in the wide-body market, such engines will still produce a stable demand. Its installed base of civil and defense engines has now reached 29,000, providing long-term annuity of aftermarket services revenue and also contributing to its strong customer loyalty. Bullish investors could be correct that RR is simply going through a transitional phase as returns on invested capital is expected to exceed costs of capital over a 5-year forecast period. In the coming years, RR could diversify its order book by leveraging its aero-engines into areas such as marine, energy power generation, and power systems.
But most importantly, RR has chosen the path of wide-body engines - a path of no return. While it has strategically spent billions of dollars in wide-body R&D, its narrow-bodies progress has lagged significantly. As a result, there currently exists a duopoly in narrow-bodies with CFM International and Pratt & Whitney. RR's gamble to pursue wide-bodies could pay off in the long run, however, growing headwinds in the wide-body market have ultimately caused analysts and investors to shy away from the company.
- Public opinion of new CEO Warren East;
- Fleet capacity outlook for 2018 and beyond;
- Future company statements and if RR continues to drive down market expectations;
- Extent to which Trump's proposed increased defense spending will be in effect: could cause a global security dilemma that benefits the Aerospace & Defense industry.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RYCEF over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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