Safran

Safran is a great business whose share price has been cut in half.

Its "Fly-by-the-hour" and maintenance revenues make it partially a proxy for air travel.

Business

Safran is in the Aerospace industry, their 2019 segments are:

• Propulsion.  Building (OE), maintenance (MRO) and spare parts for jet engines.  Almost half of company revenue.  56% of their propulsion revenue is from services (maintenance and parts), the rest is from OE.
• Aircraft equipment, defence and aerosystems: 37% of company revenue.  1/3rd of this segment's revenue is from maintenance.
• Aircraft interiors: 9% of company revenue.  One quarter of this segment's revenue is from maintenance.  From the 2018 Zodiac acquisition.

The crown jewel is jet engines.  In the narrow body market, their CFM-56 engine (co-owned 50/50 with GE) is the world's best selling aircraft engine, on the back of secular LCC growth.  They look to continue this dominance as they transition the old CFM engines to the new LEAP, which will work on the Airbus, Boeing and Comac planes.

Their only competitors in narrow body are P&W, and possibly a Chinese supplier for Comac.

2/3rds of 2018's Propulsion revenue was from CFM. So around 1/3rd of company revenue.  Could not find a profit breakdown.

In the wide body market, Safran has been involved the GE90 through its 23.7% stake.  This revenue will fall, as it is replaced by the GE9X, in which they only have an 11% stake.

In the mid range market, they have an 8% stake in the GENX engine, used by the B787 Dreamliner.  This revenue will probably increase in future, as B787 sales continue.

They target different margins for the operating segments:

Contract Liabilities

This is the by far the company's largest liability.  What are they?

Prior to 2018, "Fly-by-the-hour" revenue was recorded when paid, and lumpy costs (eg: 5 year overhaul) were artificially smoothed out:

Source: Safran IFRS 15 workshop (p6) 

For 2018 onwards, with the adoption of IFRS 15, revenue is adjusted to follow the real costs:

Payments in advance (in excess of revenue) are recorded as contract liabilities, against the new cash (asset).  When the lumpy costs occur, they are charged, and the corresponding contract liabilities  are reduced (along with the cash used to pay for them).

Financials and Liquidity

How long can they last in the current crisis?  Without external funding.

Their balance sheet is passable.  Against an adjusted (p15) PBT of 3.7bn, net debt is around 4.6bn.  The main liability is 10.4bn of contract liabilities, we don't know how many years later they are due.

For the income statement:

• 25bn revenue, 21b costs, 4bn profit.  A 14% operating margin.
• Of the 21bn: 14bn of the costs are variable (6bn raw materials, 5bn subcontracting, and 2bn external services).  1.6bn is D&A - ignore it.   6bn are personnel costs, take them as fixed.  Interest cost is neglible.

Last week they announced:

• Net debt is has now decreased to 3.2bn
• Dividend is cancelled
• Cash is 3.1bn, of which 2.8bn is accessible within 90 days
• They have an undrawn 2.5bn revolving credit facility till end 2022.
• 2.8bn of debt is due this year, they are arranging a new 3bn credit line up to 2 years.  My guess is that this can be done, unless banks run out of money (everyone takes loans at once).  This is not a credit crisis like 2008.

In the worst case, I think this can last them at least 5 months.  Its a blind guess, no one knows how much things can choke up, from the airline customers to Boeing and GE, all the way down the supply chain to the company who makes the rivets.

Their finances are not as conservative as I'd like, a company with so many accrued contract liabilities should have more cash.  Still, leverage is low, and they are not as indebted as the typical US company.  A bit hard for me to make a decision, for three reasons:

• There's a possibility the covid crisis lasts more than 5 month.  Will be a while before people book holidays again.
• Many airlines will go bankrupt.  Demand for planes drops off a cliff.
• There may be supply issues along a complex supply chain.  If any one part fails (one company under lockdown), the whole aircraft is unfinished.  Its not like a Big Mac, where you can still make one without pickles or sesame seeds.

I am undecided.  They can probably make it through, but not sure.  I'm sure that if they ran into problems the French government (or even private investors) would finance them, but I would want to buy shares after it happens.

Risks

Longer term:

• Other countries may try to break the Boeing/Airbus duopoly on narrow bodies.
• I wonder if people will travel less as the world becomes less globalised.

Valuation

Doing it based on their peak (pre virus) 2018/2019 earnings for cashflows.

• On earnings, a price of EUR 90 is 22X 2018 earnings, and 15X 2019 earnings.
• On company calculated free cashflows (p24), a price of EUR 90 is 22X 2018 FCF and 20X 2019 FCF.

I would probably buy somewhere between 12X and 15X peak FCF.  Around EUR 49 to 68.

Conclusion

Great company.  Not sure if I would buy at current valuations.  They can probably survive a covid slowdown/lockdown without external funding, but not 100% sure.

I think the bear market is not over yet - one month is too short.  Later on, the stock price may be lower, and we may have a better idea about how well they can survive.

Misc

When reading company materials, they use the word "recurring" for any operating income.  This includes OE, it does not just mean services.

They don't seem to release detailed quarterly results, which will make it harder to track their financial position in a few months.  Track their press releases instead.

2018 had substantial contract liabilities added (p87), which will make the CFO seem better than it really is.  Not sure about 2019, as the detailed cashflow statement is not release yet.

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.

Valuation

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.

Conclusion

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.

Rolls Royce: Aircraft and Engine retirements

Roll's recent profit warning was due to the transition from old engines to new one.  Old planes are being retired, reducing maintenance income, while Rolls is still waiting to ramp up production in new engines.

I need to get some idea of the numbers of aircraft being retired in the future.  Is there more to come?

First, lets look out the different aircraft models based on range and payload:

Ignore Narrow body aircraft at the bottom left, which are irrelevant to Rolls.

Jumbos, in the top right, are large 4-engined planes.  They are now a niche product: for polar flights, freight, or busy slot-constrained airports.  They are only profitable when full, which is risky for airlines as they can't scale down.  Passengers also prefer greater frequency with smaller planes.  B747s are being phased out for passenger use, and the is A380 only successfully used by mid-east carriers.

Soonest to be replaced will be the B747s and A340s, due to their fuel-guzzling 4 engines.  Followed by the B757, now also out of production.  They will be replaced by the B787, A350, future B777X and future A330neo.

Its not a 1-1 replacement.  Larger aircraft are more profitable (when full), but more risky to operate.  For example: an A350 gives better per seat fuel milage, but may be harder to fill, so could be substituted by 1.x B787's, allowing the airline to scale down the route when necessary.

How long do planes last for?  The lifespan of a Wide-body averages 25 years.  It depends on the individual plane's model and milage - some last 35 years.  Freighters tend to last longer.

(Source: Avolon white papers 2015 and 2012.

To estimate the number of aircraft retiring, I searched the www.airfleets.net production list for all aircraft in the "Wide Body" and "Jumbo" categories above.  I only took currently 'Active' aircraft, ignoring 'stored' ones and did not distinguish between passenger or freight (or the occasional military).  Then I added 25 years to the each plane's first flight year, to estimate when it would retire.  The resulting graph gives the number of Rolls Royce engines due to retire in red and non-Rolls engines in green:

Again, it is number of engines, not planes.  And its only a rough estimate, as each plane could retire up to 10 years earlier or later.  So we can't predict the timing of any more earnings surprises in the future.

What we can tell is:

• The numbers expected to retire are around 50 engines from 2014-2016, 150 engines from 2018-2022, and 150-200 engines from 2023-2026.
• The predicted retirements match favourably with engines coming on line in the next few years.  Around 780 A350's are on order, but their rollout is constrained by Airbus' production rate.  Its currently 3 A350's per month (i.e.: 72 engines per year), expected to raise to 10 per month (240 engines per year) in 2018.  And maybe 13 planes/month (or 312 engines per year) after that.
• Plus another 350+ B787 planes (700+ engines) from the current order book, lets say over the next 9 years.

Based on the order book and the projected number of engines retiring, Roll's problems of retiring engines are temporary.  In the long run, there is no evidence that the number of engines maintained will drop, and it will probably increase.

Rolls Royce: Cashflows

A look at Rolls earnings and cashflows.  Same as for any company I want to buy. 

Earnings vs Cashflows

First, ignore the Net Financing.  These contain large profits or losses from their currency hedges (mark to market), irrelevant to their underlying business.  All the earnings below exclude this.

Lets see how past earnings and cashflows compare:

The stated earnings “smooth-out” the Cash Flow from Operations (CFO).  Sometimes they are higher, sometimes lower.  For the next two years, CFO is expected to be below earnings as large numbers of new Trent 1000 and XWB engines are built at a loss.  When this happens, revenue and profits from future maintenance and long term contracts are recognised at the initial point of sale and held on the balance sheet as assets under Accounts Receivables.  In detail:

All these assets are held under "Amounts Recoverable from Contract" under Receivables.  TotalCare Assets (in blue below) have risen to form the majority of these:

This is a risk, given given the uncertainty in estimating the revenue and costs of long term contracts.  Rolls gave an model example for a single contract (slides/transcript):

The resulting profit (and difference from cashflows) is modelled as:

The modelled profit/cashflows over the product's lifecycle (building many engines over the decades):

In Roll's 1H2015 presentation (p24), the cashflows for their newest engine show that they expect it may be a drain on cashflow for a few more years:

I don't think there is anything funny going on, but earnings will be below cashflows for the next few years, and I need to understand this if I'm going to hold the shares. As investors, we have no way of knowing how aggressive their accounting is.  Their accounting practices were reviewed by the FRC in 2014, where they agreed on the treatment of TotalCare.

The expected free cashflow for 2015 is between -150m to +150m (p17).  Essentially zero.  I'm guessing it may be negative for a few years after that.

There may be write offs risk if flight hours decrease suddenly (e.g.: SARS, financial crisis) or planes are grounded.  If that happened, I'd regret buying the shares before the write-off, instead of after.

Cashflow Generation

A look at Cash Flow from Operations and Cash Flow from Investments.  Major acquisitions/disposals and one-off events for CFI are annotated:

Both annotated acquisitions are for non-aviation businesses.  Without them, they would have generated cash every year.  Hopefully the new CEO will stop.

In the long run, ten years or so, if Rolls wants to develop a narrow-body engine, that would take considerable investment.

Conclusion

I like the company.  If the A350 is a success, earnings should trough in 2015, though free cashflow may be negative for a few years after.  Biggest risk is a recession, financial crisis or SARS/911 type of event, which could affect their revenues and may lead to write-offs.

Bought Rolls Royce (RYCEY)

The idea for buying this is clearly explained by Bronte Capital here and here.    It depends on the success for the A350, the B787 Dreamliner (Rolls has about a 30% engine share) and the upcoming A330neo (expected end 2017).  The main competitor for the A350 is the B777X, expected in 2019.

Based on their order numbers for the Dreamliner (~300 planes), A350 (~800 planes) and the a330neo (~140 planes), with Airbus’ expected A350 production rate, I’m guessing a large ramp-up in 2017-2019 (190 planes in 2017, 240 in 2018 and 2019).  The company provided slightly more optimistic charts:

(Source - June 2014 presentation - p21&22)

Roll’s civilian aerospace 2014 income is about 50% recurring (services) and 50% project based (OEM).  The industry is a simple duopoly.  The only risk I can see is something unexpected happening (e.g.: SARS, 911, financial crisis), or the end of a typical expansion cycle where everyone realises too late that the’ve all added excess capacity.  This would affect Roll’s OEM revenue as orders are cancelled, and their service revenue (power-by-the-hour) shinks as revenue/profits are recognised based on expected flight hours.

Underlying PBT guided for 2015 was 1.4-1.55bn pounds, giving at the lower bound, an EPS (before tax) of 73.9p, or EPS (after tax) 56.2p.  At 900p, thats a PE of 16.

The idea of RR selling its under performing assets (1), (2) is unlikely due to the UK government’s golden share.

For me, the potential reward os worth the risk, after buying I'll still be 78% in cash.  Hard to find anything to buy.

Bought 304 RYCEY ADRs at USD 73.0955.  Total cost was USD 22,229.98.

Paperwork stuff:

• One ADR (RYCEY) equals 5 LSE shares.
• Later on, check my dividends to make sure the are not taxed: UK shares should not be, neither should their ADRs. Check the fees BNY Mellon charges (should be 1-3c/share) for the dividend payments.
• Held in my Schwabb account.  Should be a long term holding.  Counterparty risk through Schwab and BNY Mellon.  No way to avoid this for UK shares unless opening a CREST acct.