Company Reports

Narrow-moat Rolls-Royce delivered another strong set of earnings for 2023, with a record-high group profit margin driven by civil aerospace performance. We are increasing our fair value estimate from GBX 289 to GBX 380 driven by a higher confidence on civil performance delivery.

Rolls-Royce holds a prominent position in the global commercial and military aerospace propulsion and power system sectors. Its commercial aerospace segment generates approximately 50% of group sales, and the company is a market leader with a dominant 58% market share in wide-body aircraft engines.

At its Capital Market Day on Nov. 28, narrow-moat Rolls-Royce presented an in-depth view of its latest strategy and medium-term objectives. Based on the quicker-than-anticipated recovery of wide-body engine flying hours and improved profitability in both the civil aviation and power system sectors, we've increased our fair value estimate for the company from GBX 223 to GBX 289.

Rolls-Royce holds a prominent position in the global commercial and military aerospace propulsion and power system sectors. Its commercial aerospace segment generates approximately 50% of group sales, and the company is a market leader with a dominant 58% market share in wide-body aircraft engines.

Narrow-moat Rolls-Royce upgrades full-year guidance for operating profit and cash flow, on the back of a strong set of results for first-half 2023, with a historical record-high group profit margin driven by civil aerospace performance. Although engine flying hours are still at 80% of 2019 levels, civil aerospace operating margin increased at 12.4% versus a negative 3.4% in first-half 2022 on the back of higher percentage of spare parts sales, cost efficiencies, increased time on wing, and price optimization.

After taking a fresh look at Safran, MTU Aero Engines, and Rolls-Royce, we have confirmed our economic moat ratings but materially increased our fair value estimates to account for a post-COVID-19 air traffic recovery in civil aerospace and pent-up demand in the original equipment segment and aftermarket.

Rolls-Royce holds a prominent position in the global commercial and military aerospace propulsion and power system sectors. Its commercial aerospace segment generates approximately 50% of group sales, and the company is a market leader with a dominant 58% market share in wide-body aircraft engines.

Rolls-Royce entered the coronavirus pandemic in a weak position relative to peers as it was addressing major issues related to its Trent 1000 engine. The group’s civil aerospace segment, which supplies and services engines for the wide-body market, was particularly hard-hit as a result of the drop in demand for new aircraft and a sharp decrease in flight hours for its in service fleet--which is the core driver of group profits. The group responded with a cost-restructuring program, a GBP 2 billion rights issue, and the disposal of assets expected to bring in an additional GBP 2 billion.

Narrow-moat Rolls-Royce reported higher 2022 revenue and operating profit than we forecast. The business benefited from a more favorable operating environment as well as tighter management of contractual terms and pricing. We maintain our GBX 105 fair value estimate. The company is working toward restoring its balance sheet and investment-grade rating. While not making it past that goalpost yet, Rolls-Royce was able to pay back GBP 2 billion in loans in 2022, leading to a net debt reduction to GBP 3.3 billion from GBP 5.2 billion. This debt reduction was possible due to positive free cash flow generation of GBP 505 million and more significantly EUR 1.8 billion in proceeds from the disposal of ITP Aero.

Narrow-moat Rolls-Royce’s trading statement on Nov. 3 did not contain many new insights. Full-year guidance for slight revenue growth, flat margins, and modest free cash flow was maintained. The group finalized its disposal of ITP Aero and used the proceeds to repay GBP 2 billion of loans—this goes some way to restore the balance sheet, but a lot of work still needs to be done to restore its investment-grade credit rating. Cost inflation will be somewhat offset by price escalation clauses, while supply chain disruptions will result in higher inventory levels. Rolls-Royce is trying to sell the long-term story of growth in its new markets segment, which includes electric planes and small modular nuclear reactors. Although we believe Rolls-Royce has the capabilities to invest in these growing markets, they are far from being commercially viable and the medium-term prospects of the group will rest on the performance and recovery of the civil aerospace segment.

Narrow-moat Rolls-Royce reported a very pedestrian set of first-half results. Its operating profit in the first half of GBP 125 million is less than half of last year’s level largely due to a foreign-exchange charge of GBP 270 million and lower profits in the defense business. The power systems business was the only bright spark in the portfolio with tripled EBIT due to strong sales growth and operating leverage. Cash flows improved by GBP 1.1 billion, just below neutral. Full-year guidance for slight revenue growth, flat margins, and modest free cash flow was maintained. Rolls-Royce is trying to sell the long-term story of growth in its new markets segment, which includes electric planes and small modular nuclear reactors. Although we believe Rolls-Royce has the capabilities to invest in these growing markets, they are far from being commercially viable and the medium-term prospects of the group will rest on the performance and recovery of the civil aerospace segment.

Narrow-moat Rolls-Royce’s trading update for the first four months of the year was light on information. Outgoing CEO Warren East said the performance is in line with expectations and full-year guidance is maintained. As a reminder, full-year guidance as communicated in February for slightly higher revenue and flat margins disappointed investors as they expected the global recovery in flying hours to have a more meaningful impact on financials. Rolls-Royce is trying to sell the long-term story of growth in its new markets segment, which includes electric planes and small modular nuclear reactors. Although we believe Rolls-Royce has the capabilities to invest in these growing markets, they are far from being commercially viable and the medium-term prospects of the group will rest on the performance and recovery of the civil aerospace segment.

Rolls-Royce entered the coronavirus pandemic in a weak position relative to peers as it was addressing major issues related to its Trent 1000 engine. The group’s civil aerospace segment, which supplies and services engines for the wide-body market, was particularly hard-hit as a result of the drop in demand for new aircraft and a sharp decrease in flight hours for its in service fleet--which is the core driver of group profits. The group responded with a cost-restructuring program, a GBP 2 billion rights issue, and the disposal of assets expected to bring in an additional GBP 2 billion.

In light of supply chain bottlenecks and potential raw material shortages, which have intensified as a result of the war in Ukraine, we reassess our forecasts for wide-moat Safran, wide-moat MTU Aero and narrow-moat Rolls-Royce. After making short-term downward adjustments for sales growth and profitability the fair values of the firms in question do not change significantly. This is due to the long-term nature of their respective sales cycles, with the bulk of the value captured in later years. Safran’s fair value estimate remains unchanged at EUR 150 per share, while MTU Aero’s is lowered to EUR 200 per share from EUR 212, and Rolls-Royce’s fair value estimate is now GBX 105 (ADR: $ 1.40) compared with GBX 115 (ADR: $1.60), previously. We continue to prefer Safran, which trades at a hefty discount to our fair value estimate, while Rolls-Royce and MTU Aero are trading near fair value territory.

Germany’s boost in defense spending, announced Feb. 27, will benefit most European defense contractors and could lead to multiyear increases in the growth outlook for these companies. While it is early days and very difficult to quantify the exact impact, we expect to make positive adjustments to our defense coverage. Of the pure-play defense names, narrow-moat Thales, Dassault, and Leonardo trade at discounts to our fair value estimates while wide-moat BAE Systems trades at a premium. We don’t believe our revisions will change this ranking by much, and our preference is for Thales and Dassault. Despite the impact from a demand and cost perspective on the airline and commercial aerospace companies we cover, we don’t foresee any structural long-term changes to their prospects and as such don’t anticipate any major changes to our fair value estimates. We maintain our preference for wide-moat Safran and no-moat Wizz Air under our aerospace and airline coverage, respectively.

Narrow-moat Rolls-Royce returned to profitability for financial 2021 and exceeded its cash flow guidance. However, news that CEO Warren East will step down at the end of the year, combined with weak financial guidance, disappointed investors and sent shares 18% lower. Guidance for low-single-digit revenue growth in 2022 and flat margins seems a bit light given the prospects for a recovery in wide-body aircraft flying hours, the key driver of group sales. We will adjust our near-term forecasts downward to account for this but expect only a modest impact on our GBX 115 (ADR: USD 1.60) fair value estimate as we maintain our medium-term assumptions.

Narrow-moat Rolls-Royce expects to beat its previous guidance of GBP 2 billion free cash outflow for 2021. This is largely due to a timing issue related to GBP 300 million of concession payments now expected to be made in 2022, so the quality of the beat is questionable. Management also made no mention of the previous GBP 750 million positive free cash flow guidance, which was already pushed out at the group’s first-half results due to delays in the recovery of wide-body engine flying hours. The group is tracking ahead of expectations with its GBP 1.3 billion cost-saving program, which will see it shed 8,500 roles, and is expected to be completed by end-2022. We make no changes to our GBX 115 (ADR: $1.60) fair value estimate as our forecasts already err on the side of caution. Shares appear fully valued at current levels.

Rolls-Royce Holdings was battling with disruptive Trent 1000 in-service engine-related problems prior to the outbreak of the coronavirus. Matters have taken a turn for the worse since the outbreak and the resulting devastation it sowed on commercial air travel. As a result, Rolls-Royce has run into liquidity problems which was addressed by a GBP 2 billion rights issue and the disposal of assets expected to raise a further GBP 2 billion.

Narrow-moat Rolls-Royce reached an agreement to sell 100% of its stake in ITP Aero to a consortium led by Bain Capital for total proceeds of EUR 1.70 billion (GBP 1.45 billion) equating to a total enterprise value of EUR 1.80 billion. The share price reacted positively to the news, trading 10% higher intraday, and while the proceeds from the sale are in line with our GBP 1.50 billion estimate, we view this as positive news from a capital restructuring and investor sentiment perspective. We will make no changes to our GBX 110 (ADR: $1.53) fair value estimate as the sale proceeds are already factored into our forecasts. We continue to prefer wide-moat peer Safran, which offers a more attractive risk/return profile.

Narrow-moat Rolls-Royce’s cost-cutting program is paying off, and the group is on track to achieve its previous guidance of reducing free cash outflow to GBP 2 billion in 2021 from GBP 4.3 billion in the previous year and turning cash flow positive in the second half. Management has pushed out the previous GBP 750 million free cash flow target for 2022, as the recovery in flying hours is taking longer than expected. Engine flying hours for the first half of 2021 were at 43% of 2019 levels and should increase in line with the recovery in global air traffic into the second half of the year. The key driver for a return to positive cash flow is the recovery in wide-body flying hours and the successful execution of the remainder of the group’s GBP 1.3 billion civil aerospace cost-restructuring program. The shares are trading in line with our fair value estimate of GBX 110/$1.53. The uncertainty remains very high due to the wide range of outcomes for the cyclical and structural recovery, and we continue to prefer wide-moat peer Safran, which offers a more attractive risk/return profile.