Sold some stocks

Last week I sold:

• DKSH.  Too small an amount to keep track of.
• Call options on an Italian bank.  They had been doing well, but dropped back down due to the Italian election

Made a negligible profit.

Last night, I sold:

• Rolls Royce (RYCEY).  Big loss of around USD 8K on this.  This has been my worst position, because of the size of the loss and the time holding it.  My mistake was buying it based on earnings 5 years ago, where I did not realize how bad the cashflows were.  Operationally, cashflows have since recovered, but the current valuation is fair - not cheap - even at 20% below my purchase price.  I sold now due to the Wuhan Virus.  China's ban on international travel groups will hurt Engine Flying Hours if it continues.  And if the virus spreads (likely), I think people will be reluctant to fly, even in US/Europe.
• Sold some small positions in oil stocks.  China's slowing economy will affect oil.

Normally I would wait for a rebound day to sell.  But I think the flu will get worse before it gets better, and the market may just be starting to price it in.

Am waiting for the chance to buy China/HKEX stocks.  If he virus peaks in April/May, when should I buy?  Got plenty of time to think about it.

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.