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.)
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.
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.
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.