Why Jet Engine Maker Rolls-Royce Is Destined For The Skies

Why Jet Engine Maker Rolls-Royce Is Destined For The Skies

over 2 years ago2 mins

Summary:

Rolls-Royce’s cash-generating business model should leave it in a strong position as the airline industry emerges from its COVID-fueled funk.

Tell us about yourself, Karen

I’m Karen Thomas-Bland, a board advisor, consultant and non-executive director. 

What’s the pitch?

A medium-term recovery play in Rolls-Royce (ticker: RR).

Rolls-Royce swung from a $7.5 billion loss in 2020 to a profit of $544 million, helped by cost savings achieved through the restructuring and a $388 million tax credit. Stripping out the impact of derivatives, underlying profits were $204 million.

The group expects to turn free-cash positive in the second half, bringing the full-year free cash outflow to around $2.8 billion. Overall, it represents a potentially strong recovery play as the world reopens.

What does it do?

Rolls-Royce's main business is producing and servicing aircraft engines, increasingly for bigger widebody planes (passenger planes with two aisles). The group’s organised into five customer-facing businesses: Civil Aerospace, Defence Aerospace, Power Systems, Marine, and Nuclear.

It is currently going through a big restructuring effort: 8,000 of the 9,000 job cuts promised have happened so far, disposals are underway, and investment has been moved away from Civil Aerospace (core division).

What’s your investment thesis?

  • Strong reputation: considered one of the best engineering companies in the world, vast and hard-to-replicate intellectual property archive which spans everything from aircraft engines to nuclear submarine reactors.
  • Steady cash flow from its business model. It sells each engine at cost price, but sells the buyer a lifetime service contract. The fee increases over time.
  • Strong order book from defence contracts.

What are the key events you’re watching?

  • Debt levels.
  • Cost control.
  • Delivery of restructuring efforts - $1.39 billion of savings targeted.
  • Progress on sustainability.

What’s the upside potential if your thesis is correct?

Could have some upside in the short-to-medium term as the world reopens. Deep restructuring should drive bigger operating margins within three to five years in comparison to pre-pandemic levels. If this does happen, it could mean that Rolls-Royce has emerged out of the crisis in better shape. Trading at 35% below estimate of fair value and earnings forecasted to grow 9.76% per year.

What are the big risk factors you’ve identified and how do you plan to mitigate them?

Debt levels (doesn’t mature to 2024), recovery of the aviation industry post pandemic (looking positive and mitigated due to Rolls-Royce being in other markets, e.g. defence), cost control in the business and delivery of restructuring efforts (this is reported to be making good progress and showing positively in interim update).

This insight was submitted by a community member for information and educational purposes. It doesn't represent the views of the Finimize team and shouldn't be taken as financial advice.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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