Sunday, March 15, 2015

Rolls Royce and the Sequoia letter

At Bronte we have a large position in Rolls Royce - the UK based manufacturer of jet engines.

Rolls is a relatively simple story - Rolls is part of a duopoly in engines for wide-bodied aircraft (aircraft with two aisles like the Dreamliner, A350, A380, 777 and forthcoming 777X).

Jet engines cost a fortune to develop and are sold at a loss - but with huge out-year maintenance streams.

The maintenance is potentially very profitable. If you sell a lot of copies of the jet engine maintenance margins can get very fat.

This duopoly is almost impossible to break. Not only would a company need to spend billions of dollars before they developed a competitive engine they would then need to sell the engine at a loss for many years until the maintenance streams come on.

Moreover it is risky.

If you attach your engine to an unsuccessful plane (like say the A340) production will be a few hundred copies - and you will eat all those development costs for smaller maintenance streams and you will not get scale on maintenance. Making unsuccessful engines or attaching engines to unsuccessful planes is a good way to lose a lot of money.

Contra: if you attach your engine to a hit plane like the 777 - especially if it is the only engine choice for that plane - you will make thousands of copies of the engine and develop scale in maintenance. And that is profitable in the billions - and maybe even tens of billions of dollars range.

Rolls has had a few less than successful planes in recent years - let by the A340 but probably including the A380. (The super-jumbo is wondrously fuel inefficient.)

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The bull story revolves around the A350. On paper this new plane is the most fuel efficient long-haul plane in the world - and if that is true it should - over time - receive thousands of orders. (The current order book is slightly over 800.)

On paper Boeing's forthcoming 777X is a match for the A350 in fuel per seat kilometer - but that plane is still a paper plane. It has not flown yet.

Rolls Royce is the monopoly engine supplier to the A350. GE the monopoly on the 777X.

At Bronte we spent considerable time trying to work out whether the A350 was as fuel efficient as it was claimed to be. (Other planes, notably the A380, have not met spec.)

If the A350 meets spec and does not fail on safety then Airbus will sell many more than the current forward order book and Rolls will have a super-successful engine on its hands. Revenue will more than double over time. Operating margins will probably also double. Rolls Royce stock will be a big winner.

A test flight came through Sydney and we tried to get the fuel loading statistics from the airport. (No we are not kidding. Alas the plane was refueled by Virgin Australia and not Qantas. I could not get through.) We had other methods to try and assess the numbers too.

That question really comes down to carrying capacity. The A350-900 is claimed to be able to handle 314 passengers fully loaded. No plane has yet been fitted out with more than 300 seats but some are being delivered later this year with 306 seats.

If the plane is overweight (because it does not meet specifications) then it won't be able to carry that much load. In that case the airlines would need to spread the seats out. Passengers love this (more leg room) but airlines hate it. Fuel efficiency is compromised.

Alas the plane that came through Sydney was fitted out with about 260 seats - it was really spacious. This could have been because the plane was overweight - or it could have been because they wanted the plane to appear spacious as Airbus was merely drumming up orders. We could not tell.

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We finally have a definitive answer. We have discussed the matter with pilots who have seen the training manual. That includes take-off weight specs and fuel specifications.

The plane is as good as its specifications.

And Rolls Royce should be a great stock.

This is old-fashioned in-the-weeds stock research.

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There is a bad bit to Rolls Royce though. It has a business in very big diesel engines - sometimes used on ships but even more pertinently used in the stabilizer motors of large oil platforms. All of this business looks pretty bad at the moment - the cycle looks bad - and the barriers to entry look far lower than the core jet engine business.

Moreover there is no A350 on the horizon - no world-beating product that should make lots and lots of money.

It is this business - and the seeming willingness of management to commit more capital to this business - that is the bear case for Rolls.

It is also really the reason why Rolls Royce stock is a bargain.

And I have never really heard a decent explanation of why Rolls has continued to commit capital here.

But now I am hearing the whispers of activism. The latest Sequoia letter is pleading for activism. To quote:

Rolls-Royce, our largest UK position, seems willing to destroy shareholder value in the name of diversification. Rolls-Royce has a world class business making engines for wide body jets. These engines are often sold at breakeven prices, or even a loss, but come with long-term Total Care service contracts that are quite profitable. Rolls shares a duopoly with General Electric Company (NYSE:GE) in wide body engines and the barriers to entry for any newcomer would be formidable. Not only is the business intensely regulated, but a new player selling jet engines without an installed base of profitable service contracts likely would lose billions of dollars to capture market share from GE and Rolls. Not surprisingly, Rolls earns more than a 20% return on invested capital in civil aviation and its installed base of service contracts and strong backlog suggest Rolls should grow profitably for years to come. 
And yet Rolls’ board of directors decided that it wanted to diversify deeper into the marine engine and power generation businesses, competitive sectors that are being encroached by low cost Asian players. To pursue this strategy, the board appears to have pushed out a sitting CEO who had crafted the successful Total Care service contract selling model, and replaced him with John Rishton, a board member who, in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated. 
Rolls’ stock declined more than 30% in sterling during the year as investors lost confidence in management. We held our shares in the belief that Rolls’ wounds are self-inflicted and reversible. The recent share price does not properly value the civil aviation business even if we ascribe little value to the marine and energy businesses. However, management and the board seem stubborn and entrenched, and it may take a tough-minded activist to force strategic change.

I am a little happier with John Rishton. The market hatred of the man has allowed us to buy Rolls cheap. But whatever - he has a little explaining to do or the activists will get rid of him kind of fast. If the whispers get to me they have really got around Wall Street. I am kind of low on the pecking order.




John


22 comments:

Anonymous said...

Insightful and interesting. Aisles not isles however!

Anonymous said...

Maybe this Ackman guy can help you out?

Anonymous said...

Hi John, Thanks for posting your thoughts. Given your comments about diesel I was wondering what your views on Cummins are, they appear to have strong market-share and put an inordinate amount of energy (pardon the pun) into R&D. They also appear to be undervalued, some freely available overview on them by Morningstar here.

Cheers, Andrew

john b said...

"The super-jumbo is wondrously fuel inefficient."

This isn't true, or at least is misleading. The A380 is still the most fuel-efficient plane per seat on the market *if it is full*.

Airlines operating A380s on routes that are at capacity (BA, Emirates, Singapore and Qantas) have seen major cost-per-seat reductions compared to operating smaller aircraft.

The problem is, there aren't very many of these routes: they work only when you have a massive hub airport that has no room for growth in the number of flights, like LHR or SYD.

Except where the capacity to do so genuinely doesn't exist, airlines would much rather carry 550 passengers in two A330s timed 12 hours apart than a daily A380.

On the other hand, with NIMBYism increasing worldwide, and with passenger numbers continuing to rise, the number of constrained routes for which very large aircraft make sense is only going to increase over time.

Chris Hackett said...

John:

Thank you for this interesting post. Isn't Pratt & Whitney's PW 1000G engine a potential competitor on the A 350?

Chris

John Hempton said...

The PW1000G is way too low thrust for an A350. It is for the A320NEO - and I suspect it is the best engine on the market for that sort of application.

Thrust is 40 thousand pounds per engine.

The Thrust required is more like 75000 pounds -and 97000 pounds for the forthcoming A350-1000

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On the super-jumbo - frankly Bullshit.

The plane is overweight. It is fuel efficient for long hauls IF YOU FILLED It -

BUT you cannot fill it because the plane is overweight.

On the Dallas to Sydney route Qantas flies it home with 75 empty seats EVEN WHEN FULLY SOLD - because it is too heavy to take off fully loaded.

On short-haul there are more efficeint planes - and on long haul it can't be filled.

You are spouting Airbus garbage.

Sorry.

John Hempton said...

To be fair - the A380 works if your haul is less than 11 hours AND your airline sells predominently business class seats - and then you fill it with legroom - not passengers.

The plane works if you are a Middle East airline - but it does not work for anyone else.

So your line is not BS for Emirates.

But it is BS for Qantas.

wedge said...

Hi John - Curious if you have looked at Safran SA along a similar thesis but with different model exposure. It's a bit more expensive but with less product uncertainty. The company has leading share on the narrowbody jets of both Airbus and Boeing (A320 and B737) and is positioned to maintain this share on the upcoming refreshes (A320neo and B737MAX, respectively).

Anonymous said...

You skipped the other potential bull case on RR - the corruption investigations. They are my guess as to why the CEO got pushed.

Anonymous said...

UTX should bid for Rolls. The sell side seems to be interpreting the above that UTX is now focused primarily on BIS and largely ignoring the potential for an aerospace deal. Within aerospace, taking into account the size ($25bn), relative valuation, UK listing, Rolls Royce (RR) would tick all the above criteria. Moreover there could be tax advantages associated with RR’s UK domicile to boot. When you factor in the strategic rationale, if I was CEO of UTX, a deal for RR would supersede most others (in BIS). Post RR’s sale of their narrow body JV to P&W in 2012, for the first time ever, RR and Pratt and Whitney do not compete directly. RR is exclusively wide body, whereas P&W is exclusively narrow body, thus any deal should not trigger any anti-trust concerns. There could be political pushback, given the (i) UK governments golden share, (ii) RR’s manufacturing base in the UK, (iii) UK listing and (iv) RR have some strategically sensitive nuclear businesses (trident submarine and energy). However there is no reason why RR’s wide body manufacturing base would not be kept in the UK given P&W has no manufacturing capacity, whilst P&W’s narrow body could remain in the US, since RR lacks that capacity. If necessary, the nuclear business could be sold (for example to BAE), spun off or held (if the UK government approved). The UK already buys much of our strategic armaments from the US and they are our closest ally. There is no reason why there could not be a dual listing? The UK government has been amongst the most welcoming to foreign takeovers and I would note that GE recently successfully acquired Alstom in France, which has been amongst the most hostile.

Anonymous said...

United technologies (UTX) announced a new CEO last quarter and in December he announced he will consider acquisitions as he reviews UT’s portfolio. In terms of size, he is looking for big deals, “in excess of $20bn”, “bigger than Goodrich” (which was 16.5bn in 2012). UTX’s M&A in recent years has focused almost exclusively on aerospace but management will expand the focus to include BIS businesses (Building and Industrial systems) simply because there are more opportunities. For tax efficiency, UTX would likely be biased towards using their $5bn of cash sitting overseas, versus acquiring a US listed business. Management is very conscious of not overpaying. The sell side seems to be interpreting the above that UTX is now focused primarily on BIS and largely ignoring the potential for an aerospace deal. Within aerospace, taking into account the size ($25bn), relative valuation, UK listing, Rolls Royce (RR) would tick all the above criteria. Moreover there could be tax advantages associated with RR’s UK domicile to boot. When you factor in the strategic rationale, if I was CEO of UTX, a deal for RR would supersede most others (in BIS). Post RR’s sale of their narrow body JV to P&W in 2012, for the first time ever, RR and Pratt and Whitney do not compete directly. RR is exclusively wide body, whereas P&W is exclusively narrow body, thus any deal should not trigger any anti-trust concerns. There could be political pushback, given the (i) UK governments golden share, (ii) RR’s manufacturing base in the UK, (iii) UK listing and (iv) RR have some strategically sensitive nuclear businesses (trident submarine and energy). However there is no reason why RR’s wide body manufacturing base would not be kept in the UK given P&W has no manufacturing capacity, whilst P&W’s narrow body could remain in the US, since RR lacks that capacity. If necessary, the nuclear business could be sold (for example to BAE), spun off or held (if the UK government approved). The UK already buys much of our strategic armaments from the US and they are our closest ally. There is no reason why there could not be a dual listing? The UK government has been amongst the most welcoming to foreign takeovers and I would note that GE recently successfully acquired Alstom in France, which has been amongst the most hostile.

Anonymous said...

I went and browsed parts of the Annual Report. RR lost over a billion pounds on marking to market certain derivatives.

At page 31 they say: "The mark-to-market adjustments are principally driven by movements in the GBP:USD exchange rate which moved from 1.65 to 1.56 during 2014."

At page 32 they say: "The USD hedge book increased by 4% to US$25.6 billion. This represents around four and a half years of net exposure and has an average book rate of £1 to US$1.61."

Today the exchange rate is $1.47. If they lost over a billion pounds on the move from 1.65 to 1.56 then it seems to me that they have probably lost another billion pounds on the move since January 1 from 1.56 to 1.47. That should result in dreadful reported results for this quarter.

Or am I missing something here?

Tim said...

Remember, the UK holds a "Golden Share" in Rolls. There is NO taking it over by someone else who isn't British. Perhaps in a pinch the UK "might" allow a merger with SAFRAN(of France) but even though would be highly fraught politically. The only possible avenue is for Sequoia to "maybe" cobble together a UK based board slate that "might" be acceptable to the UK government.



On the subject of the A380 my personal view is many of the plane's issue are related to the fact that many airport simply lack the necessary ground infrastructure to accommodate large numbers of A380(including LHR and SYD). While LHR could in theory through further infrastructure improvement to its terminals squeeze in more A380s unbeknownst to the travelling public many airports such as LHR have already gone massively in debt to finance existing improvements. LHR has almost a 15 to 1 debt equity ratio while Charles De Gaulle in Paris is something closer to 1 to 1. Yes London is bigger market for business travelers but just the debt service is making LHR incredible expensive to operate at relative to Paris CDG. Paris CDG of course by being a much bigger airport with tons of extra capacity has no real incentive either to accommodate more A380s.

Tim said...

John - thanks for this.

A few questions:

1) How do you expect jet fuel prices at today's level to influence future orders?

2) GE notably passed on this work back 8 years ago when RFP were going out citing an inability to make the needed investment work. Further, some notable issues have appeared across the A350 supply chain (see SPR's learning curve tracked on the 787) - do you see any reason to believe RR might take impairments on the program should deferred production costs across the supply chain continue.

3) How does "power-by-the-hour" and related usage contracts on engines impact the high-margin maintenance work you cite. Perhaps in this case, as RR is the only engine supplier, the point is moot.

4) Warburg recently made a large investment in Wencor, a leading PMA manufacturer for mission critical engine parts and HEICO continues to trade at very high implied growth rates. How do you mitigate the risk to the maintenance cash flows from the growing aftermarket segment?

Thanks

Anonymous said...

John:
(1) Interesting FT article at http://www.ft.com/cms/s/0/fc4b1e4a-cb39-11e4-8ad9-00144feab7de.html
(2) Secondly the following press release suggest that the A380 has been used as a 'flying test bed' for the Trent XWB - http://www.airbus.com/presscentre/pressreleases/press-release-detail/detail/a350s-trent-xwb-engine-makes-successful-first-flight-on-airbus-a380-test-aircraft/
(3) I think the testbed was to test the engine for another Airbus plane (?A350) but interesting as would suggest that RR and Airbus have characterised the Trent XWB.

Anyway - will u be at CampAlphaville this year (loved your talk last year).

Foolish Jordan said...

John,

You spent a lot of time talking about fuel efficiency. With oil in the $50's, it seems to this amateur that this must be much less important than it was a few years ago.

Are you ignoring the drop in oil price because you think it is only temporary, or because the economics of airplanes means that even in the $50's fuel efficiency is still very important, or something else?

Thanks!

John Hempton said...

Low fuel prices are not as good for Rolls Royce as I would like as they remove the immediate pressure to replace the plane. But the difference is large - and the planes last 20 plus years. So I am not that concerned.

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It is more important for narrow bodied/short haul as fuel is a smaller component of total costs AND the engine improvements are thinner (10 percent rather than 20 percent).

This is an issue for Pratt and Whitney - and also - alas for MTU Aero Engines.

MTU is one of our biggest holdings.

J

Thomas said...

I'd be surprised to see much performance from RR/ before the point of maximum stress for the BalSh...which is 2018.

Anonymous said...

take a look at, http://www.airliners.net/aviation-forums/general_aviation/read.main/6347150/

info on the trent 1000, etc.

muscleman said...

Hi John,
Thank you for this idea. I looked at RR's numbers but couldn't figure out the valuation for its totalCare contracts. What's your thought on that?
The business model looks similar to TransDigm, where they provide maintainence for critical parts of the airplane, and they can keep raising the prices. TDG seems to be trading at 15 times P/FCF right now, with a great CEO at helm. RR's FCF seems weak right now, but may be improved when the new CEO comes in.
With the given uncertainties of RR, if you are only allowed one investment, would you buy TDG or RR?


Thanks!
Muscleman

Connelly Barnes said...

Not cheap enough. No catalyst.

Anonymous said...

I understand Rolls being the poster child of the aftermarket business model argument. But why is it then that they have barely generated any FCF even on a 10 year historical view? Sure they go through investment phases but over 10 years? Weren't they supposed to be milking the previous generation of engines at some point?

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