Saturday, October 19, 2019

Rolls Royce Update

Rolls Royce has been my worst investment, still down since I bought it 4 years ago:

Time to review this position.  If I was not holding it, would I buy it now?

The Story and the Numbers

Rolls' story is that they are slowly building up a large customer base, which will provide them with a continuous stream of payments from maintenance when flying their engines.  Do the numbers reflect this story?

Start with their cashflows.  Working capital swings wildly from year to year, so exclude it.

For the last few years, CFO (ex WC) is ~1.5bn.  With 1bn of CFI, they have 500m of cash to spare.  We can't tell how much of the CFI is sustaining, and how much is new investments.

Looking at the CFO in more detail:

For the last 2 1/2 years, operating profit is near zero.  CFO is much higher, the difference being D&A (orange) and Net Contract Assets (yellow).  The latter are the regular payments made to Rolls under Long Term Service Agreements.  Rolls charges by Engine Flying Hours (EFH).  These items have been paid for, but not recognised as revenue/income, as they are considered to be pre-payments for a 5-year scheduled shop visits (major refurb).

For the last few years we are starting to see EFH pre-payments make up a significant portion of Rolls' cashflows.

Engine Problems

Rolls has had some engine problems with its Trent 1000 (dreamliner).

  • Still causing significant customer disruption.  Fixed blades for the C variant (~50% of the fleet) may be successfully rolled (to target < 10 planes grounded) end of year.  New blades are being designed for the B variant.  New problems were found with the Trent TEN (about 1/3rd of the fleet), currently redesigning the blades, work will continue through next year. (pp5-6)
  • Cash cost for the B/C variants is expected to be ~500m in 2019, reducing to 100m next year.  
  • Cash cost for all Trent variants is 219m in 1H19 (p14).  Cash costs are included in the CFO charts above (as part of Operating Profit), so we will get a boost from their absence in future.


Rolls has long had a target of 1bn FCF by 2020.  This includes 2-300m of inventory reductions in 2020 (p18), so lets make it 750m recurring FCF.  That is 39p per share.  At a current price of 712p, its trading at 18x FCF - not cheap.

Rolls has a 'mid-term ambition' of 1 pound FCF per share (around 2bn in total).  There are 3 ways they'll achieve this (pp9-10):
  • Reducing their manufacturing (OE) cash loss per engine.  They reduced it from 1.7m to 1.3m in 1H19.  They may be aiming for 400K by 2023.  They aim to manufacture 500 engines per year (p17) over the next few years.  If they hit 1m/engine, thats an additional 150m per year (over 1H19 numbers).
  • Improving their aftermarket cash margin.  Mostly from an increased installed base of engines (more EFHs) - this is the bulk of CFO that we saw in above charts.  They expect an additional 150-200m from this.

Service Visits (SV's above) are unscheduled smaller visits, which are recognised when they take place.  Margins for SVs vary be engine type: Trent 700s have higher margin, Trent 900/1000s are lower (p10).
  • Reducing fixed costs: R&D, (Commercial & Administrative) C&A, and capex

It looks like their largest 'improvement' comes from cost-cutting.  They give the projected savings as a percentage of sales, but I think this is too fuzzy and far away to look at now.


Would I buy this stock today?  Its a question of valuation.
  • Right now, I think they can reach 1.7bn FCF (88.5p per share) in a few years.  Based on their 1H19 cashflows (920m, annualised), with continual OE margin improvements (plus 150m), increased EFH (plus 200m), and a removal of Trent 1000 costs (plus 438m).  Check 2019 Cashflows again when full year results are out - capex (CFI) will probably be higher in 2H.   
  • At 15X FCF of 88.5p, this would be 1327p, almost double its current price.  Roughly USD 17 per ADR.  Even if we cut FCF to 1.5bn, there's 50% upside.
  • Rolls story is plausible, and backed up by cashflows.  The new management looks like they will deliver the 1bn FCF/year they promised, though I think they were caught off guard by the scale of the Trent 1000 problems.
The risks are a recession (reducing EFH), or more engine faults.  A recession would invalidate all the above numbers.

If I wasn't holding now, I would buy into this.  Though I'd probably only buy half, this late in the cycle.