Rolls Royce Revisited
A few months ago we outlined our investment thesis on Rolls Royce. Last week the company provided a poor operational update and outlook and the share price fell sharply on the news. This note is a review of our thesis on Rolls Royce where we have continued to accumulate shares into market weakness.
Rolls Royce provides sophisticated power systems (engines) and services for use in the air, land and at sea. It is important to note that the company no longer has any link to the well-known auto-manufacturer. The aerospace division represents roughly two-thirds of company revenue and is the key to our thesis.
Our investment thesis can be summarised as follows:
- Air travel is a structural growth market
- Within the industry, demand for more efficient engines will continue to grow
- Rolls Royce has a strong competitive advantage within its core market (engines for large aircraft)
- As their installed fleet of engines grows, recurring service revenue will follow
- A new CEO will be able to simplify the business and improve group margins and cash flows
The two charts below show the expected growth in their core market as well as the expected engines to be delivered by Rolls Royce over the next 10 years.
Given the nature of the industry, the timing of this large backlog of engine demand converting to sales and cash flow is uncertain. It is this uncertainty that is allowing us to buy shares in the company at very depressed levels, even though we acknowledge that we have probably been early in our staggered purchases.
Despite the negative update, we remain comfortable with the long-term industry dynamics as well as the competitive positioning of Rolls Royce who operate in a duopoly in the wide-body aircraft engine market. This is supported by the fact that they are the exclusive engine provider for most of the Airbus wide-body fleet. We look forward to the new CEO providing a strategic review later in the month as to how he plans to capitalize on this strong competitive position to grow cash flows for shareholders in the years ahead.