2023-12-27 12:30:59 ET
Summary
- Rolls-Royce has been a successful investment with a 200%+ rate of return, but the position size was not significant.
- The company has undergone significant reorganization and is now focused on more resilient business models and new technologies.
- Rolls-Royce is targeting a reversal to a 13-15% operating margin and has already shown improvements in margin for every segment.
Dear readers/followers,
I've been a " buy " er of Rolls-Royce for some time - all the way up until this summer, although the company has continued to climb after that as well. However, I have not rotated the entirety, or even most of my position in the company, which is why I am still at a massive gain since some of my first pieces when the company was barely on any analyst radar, and I went positive (though not as positive as I should have), and have seen a 200%+ RoR for my position.
Unfortunately, that position was sized at nowhere near the size that it should be, so even though I've seen an absolutely massive rate of return, in terms of pure cash it hasn't been all that much compared to my other positions.
Still, all in all, it's fair to say that Rolls-Royce has been an absolutely amazing investment. One of my best investments on a TTM basis where I was clear about the time at which point I would be investing.
The reason I haven't highlighted it more, and used it as my poster case for why you should pay attention to my stances, is really that I didn't buy much of the company at the time. I bought some - but not much.
If you had more risk tolerance and actually went deeper into this company than I did, then it's likely you did far better.
I mean to highlight potential future outperformance here, but also to rein in some of the expectations that some seem to have for Rolls-Royce.
So let's see what we have here.
Rolls-Royce - A lot to like going into 2024, but the valuation is up 200%+
This company, when I started writing about it, was clearly in an undervalued state. Some operational issues and leverage had resulted in Rolls-Royce trading significantly below where it "should" be overall.
On the flip side, there were very good reasons for why Rolls-Royce was cheap. And in fact, long-term shareholders of the company cannot exactly call this a good investment at this point. Looking at the native ticker and a 10-year period paints a very different picture for this company even to the comparatively slight recovery we're seeing here.
By slight, I obviously mean in the context of the long-term trend. A 250% + RoR is not slight as such.
But this also explains to you, I am hoping, why I did not go especially deep into this company (unfortunately). Whenever a risk-reward ratio is this extreme, I tend to go for the "mini bites". This is something I usually end up regretting when the company does something like that - and it's not the first time it's happened either, which is something I mean to address in the future when I invest.
To put it simply, Rolls-Royce is a play on the company's legacy exposure to wide-body aircraft engines and other civil aerospace segments, with appealing market positions in a growing defense sector, power systems, and a growing appeal from its nuclear segment. The company has been through a significant reorganization that's bound to change how Rolls-Royce behaves as a company and as a stock.
We're talking about a more resilient business model, with a higher quality of cash flows that are both more predictable and less cyclical from its new business mix. The new Rolls-Royce has a higher focus on differentiated and "new" technologies.
I like showing numbers as proof that things are turning around, and this is very much possible when it comes to this company's recent set of annual development trends and forecasts. The company is targeting a reversal to 13-15% operating margin which would mean on its current and forecasted revenues somewhere in the vicinity of £2.5B worth of operating profit, compared to around a fifth of that in 2022.
The important thing here is that the company is already showing proof of capturing some of these targets, with margin improvements for every single segment in the 2023 fiscal.
Most of these improvements are expected to come from the civil aerospace segment, with only slight contributions expected from both defense and power systems as well as the new market segments. Once these improvements and contributions come, then this is expected to grow even further.
Right-sizing has been another mantra the company has used to address its operational footprint in the past 2 years since I've followed the company - Rolls-Royce has made hard, and the right choices as I see things here, and the total cash cost on a gross margin base is down from a 0.8x to a 0.6x with a target of 0.4x in the mid-term.
Here are the company's growth opportunities, and those are well beyond the mid-term.
The company has been busy improving its leverage and adding to its liquidity for the past two years, finally addressing the core reason for the fundamental decline in the stock several years ago. Capital allocation processes have been changed, and like many companies, the company is now focused on a quality-over-quantity approach that has been sorely lacking from many legacy businesses.
This was not specific to Rolls-Royce. I could see the same shift in infrastructure and construction companies and other industries over the past 10 years. It's been a general sort of shift where companies will no longer engage in any work unless it's "guaranteed" that they can make money off the work. You'd think that this would be a given, but if we look at Alstom's ( ALSMY ) M&A of the Bombardier part and the legacy order book there, as well as multiple other examples of companies having to execute on either loss-making or not all that profitable contracts, we can see that this is obviously not something companies have been focused enough on until now.
Rolls-Royce specifically expects the core of its business, the Civil Aerospace, and widebody EFH growth to reach well over 110% compared to the 2019 levels. The company expects higher average EFH rates, and its working capital optimizations are doing part of the job here as well. RR has managed a significant reduction in inventories outstanding (on average), with improved SCM and planning and optimized stocking. The degree of impact on the company here confirms to me just how much this was needed for the business.
Like with Alstom, the company is seeing a slow decline of its legacy agreements - it will take years for these to go away completely, and until then, RR will continue to be impaired, but as time goes by, the impairment that we can expect is going to be less and less.
Rolls-Royce has turned from a legacy player that seemingly absolutely no one seemed to be interested in owning, to a company that is seeing actual, fundamental upside going forward.
Let me clarify the risks and upsides specific to this company here.
Risks & Upside for Rolls-Royce
The Risks to Rolls-Royce are still operational, as I see it. Too much of the company's earnings and future growth/EPS is, as of yet, still highly dependent on the widebody segment. The company even says, that one of its core targets is to keep "engines earning" (Source: Rolls-Royce Capital Markets day )
What if they don't "keep earning"? The company's exposure to its widebody engines, while impressive in terms of contractual rigor and value-driven pricing, is a drawback to Rolls-Royce. The bearish thesis for this company, is in part driven by a high continued dependence on this legacy segment, with earnings from the other segments currently in many ways in their infancy - especially SMR. This means a lot of the expectations for earnings are on this part of the business, and this is never a positive in a sector as volatile as aviation/aerospace.
The company's exposure here is certainly "outsized", and this I would say is the largest operational risk faced by the company.
On the flip side, the losses from engine deliveries are expected to decrease significantly as RR's new generation engines start delivery. So while the risk is in this part of the business, the company's upside is there as well.
To call the risk/reward "mixed" here would, as I see it, be a massive understatement. Rolls-Royce remains, based on both its risk and upside, a stock with a high potential, in both ways.
This is a good time to look at the valuation and what the company has done - and what remains one of the largest issues here.
Rolls-Royce - My issue with the 2024E valuation
My biggest issue with attempting to evaluate the company at a native share price of around £3 per share is that the valuation here does not make sense to me.
Here is what has happened to Rolls-Royce in the past 10-11 years, and why you may expect the company to continue to be difficult to evaluate.
Any company with this trend is going to have a rough time, and here I'm not even including the worst of it. Note that the company for over 5 years had annual splits of its shares, and traded at negative or zero EPS for several years. Its long-term valuation trend is one of lacking clarity, and it currently trades at 32x P/E normalized. Going by earnings or any of the traditional variables is only done with difficulty, because if you forecast at the company's long-term valuation of 20x P/E, then your forward returns are only 1-2% per year, even with a 29% EPS growth rate until 2025 (per year). (Source: FactSet)
To this comes the fact that Rolls-Royce negatively misses its earnings estimates historically over 55% of the time, even with a 20% margin of error. A high uncertainty is a mild way of putting what happens with this company.
Other analysts give this company targets more or less in line with the current share price target, going from around £1-£4/share for the native, with an average of £3.1 (Source: S&P Global). I would be careful assigning any sort of significant relevance to this though, because the same 14-16 analysts gave the company a low target of £0.6 and an average of £0.9 less than a year ago, which means that they were unable to see even the short-term upside potential in a reversal for the business. They have more or less followed the way the stock has been valued by the market, almost tracing it quarter by quarter - and if that's the case, you don't need analyst forecasts for valuation - just look at the stock price, and the price it's at is what it's "worth".
I've always been consistent in my targeting at a $1/share NAV for the ADR, which is why I've been careful. I am raising my target here. That target raise only comes to a £2/share though - and although this is a massive raise, and I acknowledge the potential upside from its new business areas more than before, and also the better earnings from its legacy segments, there's still a high amount of risk baked into the stock here.
While I see incredible growth potential in Rolls-Royce, the fact remains that its overexposure to the widebody part of its civil aerospace segment and the status of its current other business areas. I'm very torn between selling what I have left and keeping it in my portfolio here, and I'll look at other potentials over the next few days and let you know what I do in the comments here.
But the simple fact is that the company, at today's valuation, trades at over 32x P/E normalized, or an inverse EPS yield of only just 3.1%, which even at this company's potential is a risk/reward ratio I do not want to engage in.
I've made outsized returns "betting" on the company's reversal here, though it did not feel like betting at the time. It was merely buying what I viewed as a quality company at an undervalued price.
Would you like to see another company that I believe will do a similar journey but has not turned around yet?
TUI ( TUIFF )
Also, a company I view as generally qualitative, turning around, and in a completely different sector. The difference here is that my position is not actually trivial, so when (not if) they do turn around, I'll be enjoying some significant returns on that investment in terms of pure cash.
And, it's already starting.
With this said, I give you my current thesis for 2024E and Rolls-Royce - that being that the company isn't in a position where I would buy it, but might actually rotate the rest.
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. The exposure to widebody aerospace is outsized, and while the segment does have advantages, the size of the company's sales mix is not one of them. When aerospace goes down, it takes the company's earnings and potential with it, as things stand.
- No yield and low visibility make this a hard sell at all but pennies on the dollar. I'm raising my target to £2/share for the native due to the impressive performance, as well as the improved earnings I see, but I see the recent bout of upswing as a clear overreaction - I don't think that things are as "positive" as many seem to want them to be.
- Because of that, I'm sticking to my " hold " at this time.
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.
Thank you for reading.
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For further details see:
Rolls-Royce: My Best 2023 Performer And The Future