Rolls Royce Is Down 40%. Time To Buy?

During that period the company had a:

• Growth Rate of 9% per year, compared to 0.8% for the FTSE 100
• Growth Quality (i.e. consistency) of 83%, compared to 50% for the FTSE 100

So in terms of growth, Rolls-Royce has grown more quickly and more consistently than the large-cap market overall.

NO – Rolls-Royce is not an especially profitable company relative to the amount of assets required to produce those profits. Specifically, it has:

• Average Net ROCE (10-year median post-tax returns on capital employed) of 8.7%, compared to around 10% for the FTSE 100

NO – There are two key financial obligations that I track: total interest bearing debts (borrowings) and defined benefit pension obligations.

If either of these is “too large” it can result in dividend cuts and rights issues as the interests of lenders and pensioners come before those of shareholders.

Rolls-Royce has borrowings of £3.2bn compared to 5-year average post-tax profits of £1bn, which gives it a:

• Debt Ratio (ratio of borrowings to 5-year average post-tax profits) of 3.2

The company operates in the defensive Aerospace & Defence sector and for defensive companies my Debt Ratio limit is 5, so Rolls-Royce is comfortably below that limit.

It also has defined benefit pension obligations of £12.4bn, which means it has a:

• Pension Ratio (ratio of pension obligations to 5-year average post-tax profits) of 12.3

I have a couple of rules of thumb which say:

• Don’t invest in a company if its Pension Ratio is more than 10
• Don’t invest in a company if the sum of its Pension and Debt Ratios is more than 10

Clearly Rolls-Royce’s pension scheme causes it to violate both of those rules of thumb. If its obligations continue to expand (they have grown from £6.5bn in 2008 to £12.4bn today) then the risks of a massive pension deficit are, in my opinion, too high.

On a positive note, the company has at least purchased “longevity swaps”, which insure it against the cost of its retired employees living longer than expected. However, those swaps only cover £3bn of the total obligation, leaving £9bn uninsured.

One other plus point is that the defined benefit scheme was closed to new members in 2007.

As a result of its massive pension obligation and deficit risk, Rolls-Royce will be excluded from my buy list until those obligations are reduced or until the company’s profits are significantly increased.

NO – Rolls-Royce’s share price has fallen by around 40% from its previous highs, but it is still not cheaper than the market average. With its shares at 780p and the FTSE 100 at 6,800, Rolls-Royce has a:

• PE10 ratio (ratio of price to 10-year average earnings) of 15.9, compared to 14.3 for the FTSE 100
• PD10 ratio (ratio of price to 10-year average dividend) of 46.1, compared to 33.5 for the FTSE 100
• Dividend yield of 3.0%, compared to 3.4% for the FTSE 100

So despite its current problems, investors must still be expecting Rolls-Royce to grow its dividend faster than the market average over the medium to longer-term, otherwise they would not accept the lower dividend yield and weaker valuation ratios.

YES – The company’s KPIs include research and development expenditure, capital expenditure (i.e. investment), cash/debt ratio (liquidity and leverage) and free cash flow (liquidity and profitability).

YES – Rolls-Royce is the second largest provider of defence aero engines and services in the world and the leading provider of engines for military transport aircraft and business jets. It also has strong positions in many of its other markets.

YES – Although Rolls-Royce started off manufacturing cars in 1906, it has been designing and manufacturing aircraft engines for the military since the start of the First World War in 1914. It moved into civil aviation shortly after the end of the Second World War.

YES – Rolls-Royce had a difficult year in 2014 and as a result has embarked on “decisive action [which] is driving a transformation of the business”.

This transformation is currently focused on improving the 4Cs mentioned earlier: Customer, Concentration, Cost and Cash.

This is a company-wide effort but it appears to me to be evolutionary rather than revolutionary, and does not fit into the category of what I would consider high risk “bet the company” projects.

YES – Although my answer is yes, Rolls-Royce does spend huge sums on capital expenses. For example, over the past 10 capex has averaged just over £750m per year.

This need for significant capital expenditure is due to the nature of its business, which involves many years of research and development before new engines or other technologies can be put into production, and that production then requires expensive factories and equipment.

However, £750m is still less than the company’s average post-tax profit over the same period, which came to just over £1bn. This means that Rolls-Royce has an:

• Average Capex Ratio (ratio of capex to post-tax profits) of 70%

That is above average, but slightly below my definition of “high average capex”, which is anything over 100%.

NO – Rather than selling engines one at a time, Rolls-Royce signs large contracts, sometimes valued in billions of pounds, to supply and service multiple engines and power systems over many years.

Its largest contract to date has a value of some £6bn, and covers the supply and service of engines for the Emirates airline’s fleet of Airbus A380 “double decker” commercial airliners.

The company’s order book is currently valued at £74bn, so that large Emirates contract on its own makes up approximately 8% of the order book.

Although this is a significant reliance on a single contract, I don’t think the company is over-exposed to these large contracts. I don’t yet have a rule of thumb on when a contract is “too big”, but if I did I think it would be higher than 8% of the order book.

NO – In 2011 Rolls-Royce spent approximately £1.5bn purchasing Tognum, a German industrial engines group, alongside Daimler in a 50/50 joint venture acquisition. This was a “large” acquisition as it came to more than 100% of that year’s post-tax profits (which is my definition of large).

In 2014 the company purchased the remaining 50% of what was Tognum (now part of its Power Systems business) for £1.9bn. This is also classified as a “large” acquisition, costing more than 150% of that year’s post-tax profits.

This large acquisition does not appear to have destabilised Rolls-Royce and its integration appears to have gone smoothly.

On average, acquisitions for Rolls-Royce have equalled 40% of post-tax profits over the last 10 years, which is not particularly high.

YES – The only large acquisition (Tognum) is closely related to the company’s core engines business.

YES – The company is in the Aerospace & Defense sector, which is a defensive sector. However, Rolls-Royce’s largest market, civil aviation, is cyclical.

In recent years the company has been trying to diversify away from civil aviation in order to reduce this cyclicality. For example, in 2008 49% of total revenues came from civil aviation; by 2014 that percentage had dropped to 47%, which is not a massive difference.

Another way in which Rolls-Royce has tried to reduce its cyclicality is through long-term service contracts, which produce more reliable revenues and profits than the sale of new engines (called “original equipment”).

As less than half of total revenues come from the cyclical civil aviation sector and about half of total revenues come from the more defensive service side of the business, I would say it is reasonable to call Rolls-Royce a defensive company.

YES – I see no obvious evidence that the pattern of demand will change significantly in the short or medium-term.

YES – Rolls-Royce expects all of its major markets (civil and defensive aerospace, power systems, marine and nuclear) to grow over the next 20 years. I think that expectation is reasonable.

YES – Although the company’s engine and power system products do need to be regularly replaced with newer, better versions, this regularity is actually quite slow.

Many of the company’s product designs have a useful life of more than 20 years or more, with the help of interim upgrades and other improvements which do not involve a complete redesign.

YES – Through the use of patents and long, expensive development phases, many of Rolls-Royce’s products are best in class at their respective jobs. Although it is not impossible for other companies to produce better products, the difficulty of this task means its engines and other products often do not compete purely on price.

This “hard to replicate” argument is taken even further when the company’s TotalCare service package is included, where Rolls-Royce has a lot of experience of providing product-related services which involve a tightly integrated and complex relationship with its customers.

YES – Although commodities are used as inputs for its products and many of its customers are affected to a large degree by commodity price movements, they do not have a significant impact on Rolls-Royce.

NO – Although the company does focus on return on sales (11.5% in 2014) it does not have a measure for return on capital or return on investment. This is very probably tracked within the business, but it is not obviously a major focus of the company, which it should be.

YES – The company has two main intangible assets: its brand name and its collection of patents.

Rolls-Royce is known throughout the world for its engines and engineering capabilities and this brand familiarity enormously increases the likelihood that the company’s products will be seriously considered by its target audience. A much less well-known company would have a considerably bigger “credibility gap” to overcome.

Its patents are also an intangible asset. For example, in 2014 the company spent some £1.2bn on research and development, producing 600 patents along the way. In principle these patents give the company a monopoly on a particular technical solution which can make the patent-protected products hard to compete against.

YES – If an airline decided to use Rolls-Royce engines in a fleet of aircraft, and to have Rolls-Royce provide complex, tightly integrated services to support those engines during their lifetime, both companies would work to optimise related technical solutions and processes.

Because of this I expect it would be much easier for this airline to continue to use Rolls-Royce for a different fleet of aircraft, or to use new Rolls-Royce engines when it is time to replace the old Rolls-Royce engines (whether for the same aircraft or new ones).

This creates a barrier between that customer and other engine suppliers, although how high that barrier is I do not know.

The flip-side of this is that Rolls-Royce’s major competitors could also benefit from this same competitive advantage.

NO – The company’s products or services do not become appreciably better just because more customers are using them.

NO – I don’t see any obvious evidence that the company has a durable cost advantage over its major competitors.

GOOD VALUE – At 780p Rolls-Royce has a rank of 63 out of 230 qualifying stocks on my stock screen, slightly outside the top 50 which represents my definition of “good value”.

My current “good”, “fair” and “poor” value prices for Rolls-Royce are:

• Good value (top 50 rank): 700p (10% below the current price)
• Fair value (average rank): 1,050p (35% above the current price)
• Poor value (bottom 50 rank): 1,550p (99% above the current price)

I would seriously consider buying the shares at anything below the “good value” price (ignoring for now its large pension scheme).

At 700p the shares would have a dividend yield of 3.3%, more or less in line with the FTSE 100’s current yield, but from a company with an above average record of growth and perhaps greater dividend growth potential over the medium to longer-term.

At the “fair value” price of 1,050p the shares would yield 2.2% and this price is clearly achievable, given that the shares reached almost 1,300p at the start of 2014.

NO – A value trap is when a company’s shares appear to be cheap, but turn out not to be because the company subsequently runs into major problems, cuts its dividend, announces a rights issue, or worse.

In the case of Rolls-Royce its shares do appear to be cheap, but I think there is a significant risk of a reduction in its ability to pay future dividends.

The company has issued four profit warnings in the last 18 months and its latest update, published in July, outlined its current problems and their implications for the future.

It describes its current “significant market pressures” as:

• Falling sales – For its Trent 700 engine as it introduces the newer Trent 7000 engine
• Weak demand – From the business jet engine market and aftermarket
• Weak demand – From offshore marine markets

One casualty of these headwinds is the share buyback scheme, which has been suspended some £500m short of its initial £1bn buyback target.

None of these issues are expected by the company to extend beyond the medium-term. Rolls-Royce still expects to see significant revenue growth over the next 10 years.

I see no obvious reason to doubt that opinion and so I don’t think the major risk to future dividend growth is its current operational problems.

I think the more significant problem is its massive pension obligations, which has the potential to amplify the effects of any operational weaknesses.

At more than 12-times average earnings, a 10% deficit would require more than £1bn of cash to be pumped into the scheme to return it to surplus.

The company would have little choice in the matter, as it is legally obliged to fully fund the scheme.

Although, as I have already mentioned, it has taken out “longevity swaps” and has also reduced the equity allocation of its pension assets to reduce volatility and risk, to me the scheme still represents a massive potential black hole.

Although I would like to invest in Rolls-Royce, I won’t be doing so until it gets that pension scheme under control.

That will only happen if it sells some of the obligations to a third party or if it can grow its earnings faster than the pension scheme grows its obligations.

NO – Although Rolls-Royce has a Debt Ratio of 3.2, which is significantly below my limit of 5 for defensive companies, I would like to see that debt level reduced further to offset some of the risk from its pension scheme.

As I mentioned earlier, I have a rule of thumb which is to not invest in companies where the combined Debt and Pension Ratios are above 10 (currently it’s 15.5 largely because of the Pension Ratio of 12.3).

Reducing the level of debt would be a big help in reducing the risks associated with the company’s very significant pension obligations.

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Written By: John Kingham