Description

Monopolistic wide-body aircraft engine maker on the brink of multi-year growth ramp.  Trades at undemanding valuation despite highly visible growth potential due to weakness in non-core segments, turnover in shareholder base, and concerns about management quality. Significant upside as deliveries of engines powering next gen aircraft accelerate in 2015-2017.

Summary:

RR trades at a relatively cheap valuation for what is a monopolistic industrial business with enormous barriers to entry, high-visibility economics, and a compelling growth story. 

RR is now the leader in widebody aircraft engines and is enjoying the strongest market position in its history thanks to its offerings for the Boeing 787 Dreamliner and the Airbus A350XWB.  RR’s >£70bn order book represents a potential doubling of the current installed engine base over the next decade and the medium-term competitive environment is essentially secure through at least 2025. Aircraft engines are fiendishly complicated and the industry is a semi-collusive oligopoly split between RR, GE, and Pratt & Whitney, allowing for sustained, unusually high returns on capital.  The multi-decade nature of the product cycle and the almost total penetration of long-term service agreements (LTSAs) on OE sales offer an extremely high degree of recurring revenues with an unusual degree of persistency and visibility. 

The limited incremental opex/fuel efficiency that can be wrung from airframes with current technologies makes engine OEMs increasingly critical to airframe OEMs, and this growing strategic importance is matched by an increasingly entrenched aftermarket services (MRO) position for engine OEMs.  Engines are typically sold at or below cost as long as they are paired with a lifetime LTSA, which although offered in a variety of flavors, generally charge for service on a per flight hour basis (“power by the hour”). While RR has lagged its rivals in a number of respects, it has led the industry in attachment rates on service agreements.  This will make the near-term ramp in deliveries especially valuable to RR, as revenues are earned ratably even as RR’s costs are disproportionately weighted towards the second half of an engine’s life.    

The current civil aero order book is a multiple of the current EV and offers margin of safety against order cuts, a delay in the production ramp-up of Trent 1000/XWB, and underperformance in the other businesses.  While the overall size of the order book, as well as rates of new bookings, have peaked for the current cycle, past cycles suggest that there is still meaningful growth potential through the 2020s, in addition to the prospect for a handful of additional platform wins/re-engineing opportunities.  I do not believe the market is ascribing value to any potential remaining 787/350XWB new orders, which will likely continue to be sold by OEMs well into the 2020s. 

The non-aerospace (Land & Marine) engine segments are less attractive but are largely insignificant to the overall EV.  Management could potentially create a lot of value by exiting these non-core businesses and becoming the only public pureplay aircraft engine OEM, which would almost certainly lead to multiple expansion.  I ascribe relatively little value to these segments in my consolidated valuation, and if these businesses continue to underperform management will likely be under increasing pressure to spin or sell them.

Why Now:

There are many reasons to dislike RR which may explain why such an apparently high quality business franchise trades at a relatively undemanding valuation.  I think these issues are not terribly complicated to analyze or threatening individually, but sum to what I believe to be a fairly negative market consensus at odds with a business which is almost too good for this management team to screw up.

Growth in the orderbook from next gen engine deliveries has peaked, but earnings haven’t shown up yet and opex/capex have spiked ahead of the full launch of next gen production.  Sell-side analysts currently model run-rate capex/opex levels which seem to be out of whack with the nature of the production cycle and the heavy up-front investments required in tooling/engineering/etc.  Moreover, the end of peak order growth has likely led to some turnover in the shareholder base; the dyspeptic market reaction to management’s falling growth guidance seems to suggest as much.

The opportunity to time the product cycle is magnified by short-term headwinds in defense aerospace and the evolving collapse of the marine segment due its heavy exposure to offshore (~60% of segment revenues in 2014).  These concerns are immaterial to the thesis at the current valuation/size of the non-aero segments, and offer optionality should management succeed in its mission of capturing a higher portion of service revenues in both segments, or should either segment eventually show signs of bottoming.   

Sentiment on management is very poor and their track record is decidedly mixed.  Everyone I’ve talked to who knows the company mostly hates management and the sell-side has been horrified by their backsliding growth estimates. Compared to GE/P&W management, RR are decidedly more ‘European’ (i.e. slower moving, less aggressive), lack the captive financing arms of both conglomerates, and possess a third-in-class supply chain.  Although I have not met with senior management personally the people I have spoken to who have find them unimpressive.

However, none of these handicaps, by my estimation, is sufficient to overwhelm the enormous value potential of the current order book.  Management, while not especially savvy in their shareholder communications, have been shareholder friendly capital allocators and are atleast unlikely to make significant of commission. Management have announced £1.25bn in buybacks in the last few months, cut 10% of group headcount, sold a number of non-core businesses, and avoided significant acquisitions after threatening to "build scale" in Marine. (The notable exception on M&A being the buyout of JV partner Daimler in Tognum AG, but this transaction made sense given the price they paid, the potential benefits of wholly controlling the entity and the degree to which it may make it easier to sell the now wholly-owned business in its entirety.) 

Morever, even with the confused legacy group structure and underperforming non-aero segments, group returns on capital have been excellent and shareholders can expect to earn the majority of business economics.  Given the monopolistic quality of the core business, I am willing to accept relatively underwhelming management as long as they are trustworthy and reasonably decent capital allocators.  The core business is probably too good for management to blow it up, at least on the investment timescale contemplated here. 

There also seems to be a high level of uncertainty surrounding the embedded value of LTSA’s from the current order book and installed base, which is probably exacerbated by limited analyst attention given the lack of direct pure-play comparables.  I think that using relatively conservative assumptions on a platform by platform basis for civil, one can arrive at a value for the NPV of the total order book + current installed base at or above the current market cap. The degree of confusion regarding the value of the LTSAs originates from the limited amount of detail offered by RR and the comparative complexity of these agreements, which forces one to employ a number of stylized assumptions/do a lot of digging/back-in to modelling the NPV of the engines. 

Given RR’s comparatively rickety supply chain, the market may also be skeptical of management’s ability to execute on accelerating levels of engine deliveries in 2015-2017, which will result in the company delivering significantly more engines than it ever has before. I am less concerned about this weakness given the gradual phase-in of 1000/XWB production and the iterative evolution of these engine architectures (in contrast to the more aggressive innovation embraced by GE/P&W).  Moreover, I think the bulk of supply chain weakness is in the aging UK supplier base for legacy platforms rather than the increasingly globalized supply base for the 1000/XWB, and that to the extent this risk materializes it will likely affect legacy programs rather than new growth platforms.  There is however, some risk that RR will have to internalize some of its distressed supplier base for legacy platforms over time.

Valuation:

RR’s valuation is complicated by the multi-segment group structure, but I believe the comparatively undemanding nature of the valuation can be readily illustrated. 

RR currently trades at an EV of ~8x my 2014E group Adj. EBITDAR (I assume equity investments at balance sheet value, capitalize operating leases, and include all pension obligations).  On a forward basis, RR trades at ~7x my 2017E group EBITDA.  I apply what I believe to be fairly punitive assumptions for the non-civil aerospace segment, implying a ~50% fall in non-civil aerospace EBITDA from FY2013 levels.  I estimate 2017E civil aero EBITDA on the order of £1.7bn, based on planned production run-rates, which at 12x suggests >£9 of value in civil aero alone, net of all group debt & corporate overhead, right around the current share price.  While the defense aero and non-core businesses are not nearly as exciting as civil aero, they are still above-average industrial businesses which generated close to £900mm in 2014 EBITDA; this speaks to the potential value of getting rid of the non-core segments.

My earnings estimates for civil aerospace are built from the bottom-up on an engine-by-engine basis, which involves some guesswork around retirement dates and how to model LTSA economics, but also allows for a greater estimation of the lifetime value of the engine base.  I compensate by assuming flat margins over the contract life (contrasting with ratable revenues & back-half weighted costs) and accelerating retirement rates on the oldest legacy platforms. 

Another way to illustrate downside protection using LTSA estimates is by disaggregating the value of the installed base vs. the order book vs. future orders/platform wins.  I think the current installed base is probably worth anywhere from £6-9bn, which gets you pretty close to or above the current market cap with relatively punitive assumptions for the remaining non civil-aero segments.  Again, this suggests that the current consensus view is not attributing significant value to the current order book, much less the potential for future order and platform wins.  The current order book is probably worth at least this much on an NPV basis.  In general I use what I believe to be fairly punitive assumptions on retirements for both the installed base and the order book, and I essentially model a step change in engine retirements which retires the overwhelming bulk of the current fleet by the mid-2020s.

Risks & Mitigants:

Management screws the pooch, more shareholders capitulate, order book dries up. 

This seems highly improbable and would likely require an extended year+ delay in production which leads customers to abandon RR in droves.  In general, customer and airframe OEM desire to maintain a competitive duopoply widebody engine market makes a permanent loss of market position very unlikely; further, the idiosyncrasies of RR’s offerings vs. their primary competitors make RR’s engines a better choice for some customers depending on intended mission/stage length etc.  Moreover, the scenario of a failure to ramp up 1000/XWB production on schedule would not likely be catastrophic, as customers switching orders to GE would likely face an even longer delay before having service-ready engines, although it is possible that RR would be forced to offer modest concessions on LTSAs in compensation.  Barring a catastrophic failure, continued fumbles will increase pressure to rationalize the group structure. 

Middle Eastern & Asian airlines blow a big hole in the order book:

The long-term growth of air travel is well established structural trend and the current oil crash is significantly enhancing global airline economics, although the crash could also be an early warning sign of a coming Asian growth crisis.  The poor economics/highly competitive nature of the airline industry in general should help to insulate RR (i.e airlines absorb a good chunk of any shock through margins/balance sheets).  Competitive pressures create enormous incentives for customers to upgrade fleets to remain cost competitive/attractive to high value customers.  The 2008-2009 downturn did not see material cancellations and supports this view, although obviously an Asian/EM-specific crisis would likely have a more meaningful impact.

GE/P&W captive financing arms steal orders

The American engine OEMs have always used their in-house finance arms to win bids, and RR’s ability to hold its own without having to resort to finance subsidies is probably a positive.  It also reduces concerns that RR is shouldering additional balance sheet risk to goose sales.  However, it is inarguable that lacking the support of a large conglomerate like GE/UTX places RR at a comparative disadvantage. 

P&W’s geared turbo fan lets it enter widebody in a big way

P&W have made something of a quantum leap in engine design with their new geared turbofan design, which took them 10+ years to perfect and is making a big splash in narrowbody.  However, the immediate risk to RR is minimal; P&W have their plate more than full in the narrowbody market, and will enjoy no major widebody bidding opportunities for at least 5 years.  In general, engine OEMs need to be increasingly selective in deciding which platforms to bid for given the degree of resources required to develop a competitive bid, while airframe OEMs seem to be finding it more and more difficult to secure multiple competing bids and are increasingly have to award exclusive contracts. Meanwhile RR’s new next gen concept designs are importing many of the features of P&Ws design.

Antitrust enforcement action

The business economics are great for a reason and independent MROs moan and groan about the anti-competitive nature of LTSAs.  I don’t know of any antitrust action in progress; there was one recent attempt by a small MRO shop in the US but the legal hurdles seem to be significant and this case ended up going nowhere. 

Big engine blow up/smoking hole in the ground:

Engines are iterative, evolutionary designs with millions of flight hours, thousands of moving parts, and a design so complex that no one engineer is capable of understanding an engine in its entirety.  While this fact, in tandem with the extreme degree of redundancy in aerospace engineering, makes it unlikely that something fatally wrong is suddenly discovered in the inner workings of the Trent 1000/XWB, a RR-powered Qantas A380 did suffer an uncontained failure in 2010.  Despite generating some negative headlines, this largely ended up being a non-event and Qantas did not cancel its remaining engine orders.  This is a difficult risk to handicap, but the Qantas episode suggests that RR won’t see any major impact unless it is directly implicated in a major catastrophe, which would likely take years to prove in any case. 

Global pandemic or regional war leads to sustained dip in air travel; these seem to be the only things capable of seriously retarding airmiles flown on any kind of sustained basis, and obviously would have market impacts well beyond RR’s business. 

SFO corruption investigation

These allegations are probably true given the parties/nations involved, but this has dragged on forever and it seems unlikely that there will be any jawdropping revelations at this point, but what do I know.  In any case, given the value of the contracts in question here/the degree to which the scandal is embarrassing for the UK political class/David Cameron, even a historically large fine would likely be immaterial to the overall valuation.

Catalyst

Trent 1000/XWB are delivered on schedule

Defense aero/marine bottom out

Management sells/spins non-aero segments