market folly

We're posting up notes from the recent Sohn London investment conference.  Next up is Luke Newman of Janus Henderson who presented a long of Rolls Royce (LON:RR).


Luke Newman's Presentation at Sohn London Conference

At its heart Rolls Royce is a razor to razorblade business model – the razors - or the engines in this case - cost billions of dollars to design, deliver and install and come with an obligation to buy razorblades - service contracts - for the next 25 years. The gross margins on the service contracts are  high between 50% to 70% but the engines are sold at a loss.

The secular trends in air travel are supportive driven by increasing wealth and emerging markets. Air passenger kilometres over the last 70 years have grown at 6% CAGR. If passenger growth continues at 4.5% and assuming planes have a 25-year life, 425 new wide body planes are required every year to keep up with demand. That’s 37 new wide-bodied planes every month. The production schedules for Boeing and Airbus for next year are slated at 34 per month creating positive pricing dynamics for all participants.

Rolls Royce has the engine orders, the challenge is to execute: deliver the engines and carry out the maintenance contracts. There is also an organisational challenge. When Warren East took over as CEO he described Rolls Royce as an athlete that needs to lose weight. New management have been brought in to run finance and operations. A Cost reduction plan was announced earlier this year cutting 25% of non-engineering jobs. In addition, cash consumptive and loss making businesses have been sold. Rolls Royce has always traded on its high levels of technology and market share. Now Warren East is holding it financially accountable by setting cash flow targets of £1bn by 2020 and an increase to £1.8bn by 2023.

Over the last 20 years what was a 3-player market has become a duopoly. Pratt and Whitney took the rationale decision to concentrate on narrow body engines and ceded their market share to Rolls Royce. That did not come for free because Rolls Royce had to spend billions of dollars developing new engines to take the market share. The good news is that this year is the first year in which most of the revenue will come from the high margin aftermarket business. The company has reached a critical inflection point.

GE, the other member of the duopoly, has been in harvest mode, maintaining share and enjoying good aftermarket revenues. GE has lots of problems, but the engine business has not been one of them. GE’s engine margins have been consistently high.

There has been a correlation over the years between Rolls Royce’s share price and FCF per share.  The 2023 target of 1.8bn FCF should equate to a share price of just under 1000p per share.

Management are incentivised to grow FCF through bonus plans. To maximise their bonuses RR executives need to generate 158p of FCF in 2018, 2019 and 2020. Analyst consensus now is 117p – leaving 35% upside if the stretch targets are hit. Newman believes that Rolls Royce’s past performance is misleading analysts. He thinks they are behind in understanding just how cash generative the business has become.

Warren East bought £74K of stock in December suggesting he has faith in the way the business is performing. If Rolls Royce could execute as well as Safran and MTU their shares could go far higher.


Be sure to check out the rest of the presentations from the Sohn London investment conference.