Commercial aviation engine suppliers make up a relatively small world, as there are really only a half-dozen companies in North America and Europe that offer competitive solutions, and most of those don't compete across the board. Rolls Royce (OTCPK:RYCEY) is a name that is probably best known for a business it's not even in (the luxury car business is owned by BMW (OTCPK:BMWYY)), but this is the third-largest aircraft engine maker and a significant player in the markets for widebody and business/regional engines.
This is an interesting time for Rolls Royce, as the company is about to see new widebody programs ramp up (which isn't actually that good for margins), older programs wind down (which is bad for margins), and likely not much progress in non-aviation areas like marine. What's more, there are well-publicized challenges with widebody aircraft these days, as many operators are turning to more efficient, more capable next-gen narrowbody planes instead.
Although the next couple of years are likely to remain challenging, and an accounting change will hammer reported earnings (but not cash flow), I believe there's an argument to be made that Rolls Royce shares are priced to generate double-digit total returns from here.
In The Race, But Unlikely To Ever Lead
Rolls Royce generates about half of its revenue from its civil aerospace business which is, in some respects, an odd collection of specialties. Rolls Royce is the number two player in engines for widebody aircraft (behind General Electric (NYSE:GE)) and a solid player in corporate jets (particularly large cabin jets), but its position in narrowbody aircraft is insignificant and going to shrink further as legacy aircraft go out of service. While the A330 has been the single largest platform for Rolls Royce, the company's single-source position on the A350-XWB (a successor to the A340 and rival to Boeing's (NYSE:BA) 787 and 777 aircraft).
Given Rolls Royce's lack of exposure to the narrowbody market, their market share in terms of flight hours isn't as impressive - at 15% or so, it is on par with United Technologies (NYSE:UTX) and ahead of MTU, but behind Safran (OTCPK:SAFRY) and well behind GE (at around 45%).
What's more concerning is that this next generation in commercial aerospace is favoring narrowbody aircraft more than in the past and more than was expected just a few years ago. Narrowbody aircraft have become more capable in terms of range and capacity and they are more efficient to operate, so many airlines are replacing widebody aircraft with newer narrowbody options and ordering accordingly.
Given the nature of the widebody market (including significant concessions to OEMs like Boeing and Airbus (OTCPK:EADSY) on original equipment) and operating scale, I don't see Rolls Royce rivaling General Electric's margins, nor those of Safran or Honeywell (NYSE:HON). That said, margins should improve as the company progresses through these new program rollouts, with management expecting break-even margins on new Trent XWB engines around 2020 (companies like Rolls Royce, Safran, GE, et al often have to sell new equipment at low or negative margins to win the business).
The real key here is the eventual aftermarket business that comes with every engine that goes out the door. While Boeing and Airbus get advantageous pricing on new equipment, companies like Rolls Royce make their profits later from spare parts and maintenance services. For Rolls Royce, that's largely done through its TotalCare program - a "power by the hour" program where operators make regular payments to Rolls Royce on the basis of usage and where Rolls Royce then takes full responsibility for the maintenance and service needs.
When it goes well, it allows Rolls Royce to collect cash up front, smooth out the business, and most efficiently schedule and perform the maintenance work. When it doesn't go well, particularly when there are product quality/reliability issues, it can undermine a key profit center.
Close to three-quarters of Rolls Royce engines are covered by these arrangements, which is quite a bit more than for either MTU (around 40% to 50%) or Safran (around 25%), though Safran is looking to drive more in-house service and maintenance in the future.
Outside Of Defense, Rolls Royce Not Benefiting Much From Its Other Businesses
Rolls Royce has a sizable business outside of its civil aerospace engine operations, but these other businesses have struggled to pull their weight recently.
Defense is the strongest of these businesses, generating around 15% of revenue and over a quarter of profits (closer to a third in the second half of 2016). Rolls Royce has important positions on multiple programs in military transport (more than 40% of segment revenue) and combat aircraft (more than a third of revenue), including the Eurofighter and F35 programs. With older programs rolling off and newer programs not yet needing much in the way of service, margins are likely to see some pressure in the short term.
The next largest segment, Power Systems, generates around 20% of the company's revenue and a similar amount of profits. This business sells high-speed diesel engines for marine, energy, and industrial applications. Rolls Royce also has a separate Marine division that now contributes less than 10% of revenue due to significant weakness in offshore oil/gas (more than half of segment revenue) and merchant shipping (around one-quarter of revenue). Rolls Royce also has a small nuclear power business focused on reactors for military naval vessels and commercial controls for civilian nuclear power.
I believe the challenges in the widebody market, both in terms of new aircraft orders and utilization for existing aircraft, are pretty well understood at this point. While a downturn in the global economy would threaten this business, the fact remains that there are still some applications where narrowbody aircraft can't substitute for widebody and Rolls Royce is likely to see engine deliveries double from 2016 to 2020.
That said, I do have some worries that Rolls Royce will continue to lag its rivals in flight hour growth, as narrowbodies take more share. Likewise, I'm concerned that the company has lost out on some recent opportunities in the business jet segment.
A bigger question that I have is whether Rolls Royce will make a push to get back into the narrowbody segment. The company is pretty much locked out for the next decade, but there will be another design cycle in 2025-2030 and I wouldn't rule out the company investing resources into R&D to try to re-establish a presence in this market. The reason that matters is that program development costs could be significant and those are some of the prime money-making years in the model, as that's when the richer aftermarket revenue/profit streams start to kick in and boost free cash flow production.
Rolls Royce is also facing a challenge to the perception of its money-making capabilities with the adoption of IFRS15. I realize that detailed accounting discussions can be a powerful soporific for many (if not most) readers, so I'll keep this brief. Basically, IFRS15 will force the company to change how it recognizes revenue on new OE deliveries and AM services, with the company no longer booking profits on linked OE sales (linked to aftermarket contracts) or capitalizing losses on new engine sales.
The end result is that the earnings streams from new engine programs (both OE and AM) will see greater losses in the initial years and higher profits in the later years versus the previous approach. While this is significant to investors who rely on earnings-driven valuation methodologies, the cash flow impact is nil (which is my preferred approach anyway).
I'm looking for Rolls Royce to generate mid single-digit revenue growth across the next decade, with FCF margins improving into the high-single digits over time as the new engines put into service over the next three to five years go into their aftermarket maintenance and service cycles. I also expect eventual improvements in the oil/gas markets, but I think it will be a gradual recovery. Discounting those cash flows back, I come up with a fair value that is a little bit higher than today's price.
The Bottom Line
With Rolls Royce trading only a few percentage points below my estimate of fair value, I can't argue that it's significantly undervalued. Still, it is priced to generate a double-digit total return from here and there are opportunities for Rolls Royce to cut costs and become more efficient, potentially driving higher-than-expected profits and cash flow. There is also a possibility for widebody demand to recover/improve from here, and for orders to come in ahead of expectation. With all that, then I'd consider Rolls Royce a name that is worth some due diligence, but maybe with an eye toward the watch list at today's price.
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