2023-09-07 20:43:14 ET
Summary
- I've had a successful investment in Rolls-Royce, with a 100%+ return on my stake.
- I was one of the only analyst recommending a "BUY" for Rolls-Royce in 2022, indicating the success of value-investment strategies.
- I'm shifting my thesis here for overvaluation, and now consider Rolls-Royce to qualify as a "HOLD" and rotation target for my portfolio.
Dear readers,
It seems a common theme these days that when I review a business and switch to "BUY", I don't actually buy enough of a stake in the company given where we are one year later. This is the problem with a wide coverage spectrum, which I have, and where even a 1% stake in my portfolio is a non-trivial amount of capital that I consider a serious allocation.
Rolls-Royce, since I bought my first shares in the company back last year, has gone absolutely gangbusters. By that I mean that this particular investment has turned into a "three-point buck", or a 100%+ RoR. Well above since I rated the company a "BUY". A the time, I was one of the very few analysts who covered Rolls Royce ( RYCEF ). Of course, as a company has this sort of share price development...
...analysts tend to flock to the name, as we've seen here. Still, for all of 2022, I was the only analyst recommending a "BUY" here for the stock. I believe this is a clear indicator and proof that buying a value-investment company works very well. And the signs for Rolls-Royce have been positive for quite some time.
Let's review things, and see what we have here.
Rolls-Royce - Significant returns from a qualitative portfolio
The company has been "popping" for some time now. The reason I haven't been updating, aside from always electing what to cover, has been that most of the development has been within the framework for what I would consider my expectations for the company, which were positive.
Here is what I said specifically in my last article .
While it's too early to say that the company's turnaround is complete, and RYCEF will now be a solid company to really invest in, I believe it's time to say that what is asked for the company is way less than what it is actually worth - even in a conservative thesis.
( Source )
This is a fairly unambivalent and clear stance - and about a year back, the market really was treating RYCEF as though it was a company with no prospects, ignoring most of the signs for an upside. I was not.
At the same time, it's important to note that the company has ways to go. A long way to go, in fact.
Rolls-Royce has been on a spectacular decline for several years. This climb is, as I see it, only the beginning of what the future may hold for this business.
So what is the reason we've seen such a "pop" in the company?
Well, a few things, but in the end it's about the fact that the trends I forecasted - and other analysts I know expected - have materialized. You have to realize that in my experience, a contrarian viewpoint , if applied with conservative views and valuation, has always resulted in market-beating returns for me, and this time was no different at all.
Rolls-Royce has seen the beginning of a significant upside. We've seen operational improvements across the entire group. The 1H performance for 2023 was solid, but it was nothing I did not expect. Commercial optimizations are delivering very solid earnings in context, and the company is reporting significant book and order growth.
Rolls Royce raised its 2023E guidance to reflect these improvements. Not just the accelerated delivery of targets, but the materially increasing profit and FCF for the year, with significant margin improvements from a multi-segment perspective.
Here are the company's numbers for the 1H23 period.
As you can see, these improvements are material. The company has nearly doubled its EBIT margin, and more than doubled it YoY. But you also see that credit markets aren't yet convinced of this company's long-term recovery. We're still at sub-IG, and we'll see how quickly we move to the first BBB-rate.
None of the improvements came from surprising areas or variables. It's al a matter of efficiencies, end market growth (that was very much expected), commercial improvements, and better working capital. Any company that works its net debt down also sees financial improvements, especially in a market like this.
If you recall, Rolls-Royce has a few primary segments that are major contributors. The largest of these is the Civil Aerospace segment, which saw significant deliveries with a very attractive 65%+ service revenue split, and improvements of over 100% in the gross margin. The company, on this level, has really "popped", which in turn has moved its operating margin firmly from negative 3.4% in 2022 to 12.4% in 2023, coming to a segment margin improvement of 15.6% YoY. That's the power of reversal. The fact is, it could have taken another 3 months or 6 to see this - but as I saw it, a reversal was coming. And now it has.
The defense sector is also worth highlighting in any such environment, naturally.
The company is now at a backlog of almost £9B, but this segment was already very solid back last year (in fact, one of the only solid segments that the company really had). Now, we're seeing non-trivial improvements in EBIT-level margins, up almost 2%, even if gross margins are flat/slightly down.
Power systems, the smallest of the segments by far, meanwhile saw a decline in orders of 14% but is still above 1x book-to-bill, and with a ~£4B sales backlog, and the company's interesting growth areas, including the SMR and electrical segment, is seeing significant increases in R&D spend and committed funds.
This is the sort of segment you need to realize will operate at a loss for years to come (as I see it), but may eventually grow to encompass and rival all other segments the company has under its belt. But such trends will take time and money - which the company is currently putting to market.
The company's transformation program is far from finished. Even though we're seeing some of the best results in a recovery for a company like this that I can think of for the past few years, RYCEF still needs to control indirect costs, reduce net debt, and further improve the company's profitability. When looking at the WC level in terms of accounting, there's also some drag from overdue and unbilled debt - such improvements would make things look better as well. Inventories are looking to unwind from H2, and the combined results of these trends will probably result in a significant low in working capital within 24 months if the company manages these changes.
As with any industrial, focus on "actionable contracts" meaning contracts that are inherently profitable and protected from declines and inflation is the focus for the company to not get into the trap of working with orders that turn out to be unprofitable. Pricing is key, and the company is delivering pricing action across its segments.
Here is the updated guidance for the company, and this is the guidance I consider to be realistic.
As I mentioned, any stock that "pops" will gather a significant following in a short time. I started covering RR when the company troughed. I was clear at what point I would be willing to "sign on" for this recovery, and I did so when that price was achieved. Going forward, I would keep an eye not on singular orders or trends, but make sure that what I've highlighted in my previous articles actually continues. If that is the case, then there is more upside to potentially be had here.
Still, let's look at trends and valuation targets and let's see if this company can be considered a "BUY" here.
Rolls-Royce - Valuation is far more tricky than before.
The combined headwinds of a decade of what we can call "mismanagement" as well as the current no-dividend status previously made RR a hard company to get seriously into - which is also why most of the positions I know people taking with ROlls-Royce have been smaller than we might now wish they had been.
I've been following the business for several years at this point and started to write about it about a year or so, and I was neutral for a very long time.
These significant improvements now justify a serious raising of the price target for Rolls-Royce, first of all. Materialization of these expectations and the proof of a double-digit EBIT margin means that the previous sub-$1/share target no longer makes sense - even if it did at the time.
I work with the native ticker, as you might know. Evaluating the company on a standard P/E method is tricky because we've been at negative earnings prior, which dilutes any normalized P/E valuation.
In this case, we can use normalized forward earnings power and profitability indicators. On those indicators, the company has a solid current net and EBIT margins, as well as sector-average gross margins. Its balance sheet is far from restored at a negative equity-to-asset, and a negative 1.13 debt/equity, with interest coverage of sub-4x.
The 2022 numbers still show the horror show that Rolls Royce was, not that long ago.
As I said - restored is a bit of a strong word to use here. It's improved - that's for sure. The company still has high debt, however, and is low on cash. Massive dilution has happened over the past few years, and stockholder equity still shows negative relative to its assets.
But Rolls-Royce is going up.
The company trades at a native £2.15 at this time. That represents 1.39x to EV/rev, and 1.19x to sales, compared to less than 0.6x around a year ago. With earnings improved, we're now at a P/E of around 22x normalized, compared to 33x a year ago (remember, negative normalized earnings or impacted ones). On a peer average, Rolls-Royce actually looks overvalued .
It's fair to say I believe that this marks an overreaction to a very positive trend from Rolls-Royce. The market has been starved for positive trends from this company, and investors are wearing rose-colored glasses and are applying near-insane multiples and targets to this company.
As an example, the company was at a low PT of £0.6/share less than a year ago, with an analyst average of less than £1/share.
Where is the company today in terms of normalized targets?
£2.3/share. (Source: S&P Global)
No company has moves that make it worth more than twice as much in that timeframe, but these analysts would disagree. While I would say that Rolls Royce technically could trade higher on continued positive news, the fact of the matter is at over £2/share, there is so much positive baked into the stock already, and we're assuming high earnings already, that it becomes tricky for the company to actually deliver this. With current GAAP EPS estimates of around £0.08 for the year, the P/E is high. Even on the basis of 2025-2027 estimates, this company is now trading at 15-18x P/E multiples - and this is for a company that has missed estimates for years at this point.
So, despite "liking" Rolls Royce, and trying to let "my winners run", the underlying data here points to one inevitable conclusion - we have to rotate.
I would change this stance if the company drops down again, or if we're able to ratchet up the company's estimates significantly. But as any value investor, I have to be conscious not only of undervaluation but overvaluation as well.
This, while positive, is a good example of overvaluation of current estimates and expectations for the company. For that reason, while I raise my price target to where the common share now has a PT of £1.4 to account for what I consider to be a realistic 2023-2025E earnings level, I would now give this a "HOLD" - and here is my thesis.
Thesis
For now, this is my Rolls-Royce thesis.
- Great business, great exposures, great duopoly player with some really nice fundamentals - but with the pressures we're seeing, and the Ukraine war, things aren't looking better except for the defense sector.
- No yield and low visibility make this a no-go at all but pennies on the dollar. Specifically, I'd want to pay no more than 0.7-0.8X to NAV with a normalized EBIT as a base, which comes to around £1.4 for the native.
- Because we've seen RoR of over 200% in less than a year, I'm proceeding with rotation into lower-valued investments.
- Because of that, I'm now on a "HOLD" for Rolls-Royce.
Remember, I'm all about:
- Buying undervalued - even if that undervaluation is slight and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
- If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
- If the company doesn't go into overvaluation but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
- I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
The company now lacks meaningful upside and cheapness. I say "HOLD".
For further details see:
Rolls-Royce: Massive Returns, But Now Lacks Meaningful Upside (Rating Downgrade)