RR - Rolls-Royce

[doughishere]

http://www.gwinvestors.com/2015/08/22/rolls-royce-video-the-perfect-storm/

 

Is this the new form of activism....youtube videos

[muscleman]

http://www.gwinvestors.com/2015/08/22/rolls-royce-video-the-perfect-storm/

 

Is this the new form of activism....youtube videos

 

Has anyone gone through the GW investor presentation? I see RR's 2015 H1 aerospace revenue is 3.3 bn pounds. Assuming RR can get to 20% net margin, the earnings from aero space per year would be 3.3 * 2 * 20% = 1.32 bn pounds. A 10x multiple gives a value of 13 bn, which isn't very attractive.

 

When GW says 22% net margin for GE, does it mean engine sale plus service contracts combined?

[rb]

http://www.gwinvestors.com/2015/08/22/rolls-royce-video-the-perfect-storm/

 

Is this the new form of activism....youtube videos

 

Has anyone gone through the GW investor presentation? I see RR's 2015 H1 aerospace revenue is 3.3 bn pounds. Assuming RR can get to 20% net margin, the earnings from aero space per year would be 3.3 * 2 * 20% = 1.32 bn pounds. A 10x multiple gives a value of 13 bn, which isn't very attractive.

 

When GW says 22% net margin for GE, does it mean engine sale plus service contracts combined?

The 22% margin for GE is sales and service.

 

Why would you price RR at a 10 multiple?

[no_free_lunch]

Previously, they were trading around 22x earnings.  Pricing them at 10 seems like more of a conservative lower-bound exercise.  There is also some value in the other divisions.

[muscleman]

http://www.gwinvestors.com/2015/08/22/rolls-royce-video-the-perfect-storm/

 

Is this the new form of activism....youtube videos

 

Has anyone gone through the GW investor presentation? I see RR's 2015 H1 aerospace revenue is 3.3 bn pounds. Assuming RR can get to 20% net margin, the earnings from aero space per year would be 3.3 * 2 * 20% = 1.32 bn pounds. A 10x multiple gives a value of 13 bn, which isn't very attractive.

 

When GW says 22% net margin for GE, does it mean engine sale plus service contracts combined?

The 22% margin for GE is sales and service.

 

Why would you price RR at a 10 multiple?

 

Probably because I am too greedy and only shooting for the moon.  :D

It has to compete with other positions in my portfolio. For example, why would this be better than CBI, which is already 7X PE and growing at 15%?

[Picasso]

Maybe because the P/E ratio of CBI will have very little to do with the returns the business generates on your investment.  There's also the difference of long-term predictable cash flows with RR (not true with CBI), Berkshire selling out of CBI (versus ValueAct going into RR), high barriers to entry for RR, and a very long positive cycle for RR regardless of macro.  Whether they can get their margins up without a lot of capital investment is another story.

[portfolio14]

 

The most uncomfortable aspect of RR is its TotalCare contracts are blackboxes. They work like insurances. If RR makes the wrong assumptions in the maintenance cost or engine reliability (for the next 15! years usage of an engine), they will misprice the contracts and investors have no way of knowing until it's too late. We have to trust both the skills and the integrity of the management.

 

This is the main thing holding me back from clicking the buy button.

[compounding]

 

The most uncomfortable aspect of RR is its TotalCare contracts are blackboxes. They work like insurances. If RR makes the wrong assumptions in the maintenance cost or engine reliability (for the next 15! years usage of an engine), they will misprice the contracts and investors have no way of knowing until it's too late. We have to trust both the skills and the integrity of the management.

 

This is the main thing holding me back from clicking the buy button.

 

Like insurance, but (practically) without competition, you mean? :)

 

Also, I don't really see how the cost for maintenance changes dramatically without RR being aware of it. Is it really plausible for the cost per mile flown to be so volatile as to make this an important risk? After all, they built the things and have very large databases on how the engines behave/perform etc. Maybe someone else has more insight here.

[portfolio14]

 

The most uncomfortable aspect of RR is its TotalCare contracts are blackboxes. They work like insurances. If RR makes the wrong assumptions in the maintenance cost or engine reliability (for the next 15! years usage of an engine), they will misprice the contracts and investors have no way of knowing until it's too late. We have to trust both the skills and the integrity of the management.

 

This is the main thing holding me back from clicking the buy button.

 

Like insurance, but (practically) without competition, you mean? :)

 

Also, I don't really see how the cost for maintenance changes dramatically without RR being aware of it. Is it really plausible for the cost per mile flown to be so volatile as to make this an important risk? After all, they built the things and have very large databases on how the engines behave/perform etc. Maybe someone else has more insight here.

 

Imagine we wake up one day and hear this news: "Roll-Royce's Head Engineer admits they discovered a design flaw in their Trent XWB engine. He assures the public that safety and performance are not compromised. Rolls-Royce has formulated a new set of guidelines to alter the maintenance schedule and maintenance routines. Airlines covered by TotalCare are not affected materially as "time on wings" are guaranteed. However, the updated maintenance guideline will cost RR 20% more to fulfill its TotalCare contracts."

 

Oops, our 20% margin is completely gone.

 

If it were the old days with time and material, RR could've ramp the price. Airlines will be upset but still have to take it. Not with TotalCare.

 

I always have the impression that investors form the false association that TotalCare is a razor/razor-blade business model. It's not. RR can't raise price of their razor blades. Once an engine is sold with TotalCare, the revenue stream is fixed. From then on, the only lever they have is cost control. With the contracts spanning over decades, RR is taking on huge tail risk in exchange for stable cashflow. So, I really don't know what to think of it, whether TotalCare is a brilliant invention or it's a dud.

[TheAiGuy]

 

Imagine we wake up one day and hear this news: "Roll-Royce's Head Engineer admits they discovered a design flaw in their Trent XWB engine. He assures the public that safety and performance are not compromised. Rolls-Royce has formulated a new set of guidelines to alter the maintenance schedule and maintenance routines. Airlines covered by TotalCare are not affected materially as "time on wings" are guaranteed. However, the updated maintenance guideline will cost RR 20% more to fulfill its TotalCare contracts."

 

Oops, our 20% margin is completely gone.

 

If it were the old days with time and material, RR could've ramp the price. Airlines will be upset but still have to take it. Not with TotalCare.

 

I always have the impression that investors form the false association that TotalCare is a razor/razor-blade business model. It's not. RR can't raise price of their razor blades. Once an engine is sold with TotalCare, the revenue stream is fixed. From then on, the only lever they have is cost control. With the contracts spanning over decades, RR is taking on huge tail risk in exchange for stable cashflow. So, I really don't know what to think of it, whether TotalCare is a brilliant invention or it's a dud.

 

That's a risk but Rolls is always going to live and die buy its engineering quality. I'm also not sure that the sales model is a worse problem in the scenario you've laid out: if maintenance costs come out way higher than thought, that would effect their ability to sell engines with a different profit model anyway.

 

Likewise, I think you are assuming in this scenario that Rolls would be unable to adjust their engine design and/or contracts for future deliveries were they to discover such a design flaw, or that they would only discover a design flaw well into the lifecycle of the engine when it is too late. I'm not sure how realistic either of those assumptions is. New technologies routinely have problems early in their lifespan resulting in iterative improvements that is characteristic of the engineering process -- engines certainly aren't immune to this.

 

Regardless of the business model, engineering risk is a very real risk for the company and future maintenance costs are going to be a part of that. 

[KCLarkin]

There is an implied warranty anyway. If there is a design flaw, rolls will need to make good or never sell another engine. The risk is real but overstated.

[rb]

There isn't just an implied warranty with the engines. The aviation industry is highly regulated. If there is a design flaw with the engine they would have to fix it - total care or not. Sort of like a car recall.

 

Aside from these one-off design flaws I would expect after all this time that RR has a pretty good handle on the costs involved in the maintenance of a jet engine.

[no_free_lunch]

Are the total care contracts infinite or do they have a fixed contract length?  If they have a fixed contract length there should be upside due to the maintenance contracts being renewed.  I am not saying it will happen but I am not sure they are completely capped on the profits.  Of course we are talking timelines in decades.

[rb]

The contracts are fixed length

[portfolio14]

- Implied warranty has existed, yes. But in the old days, if warranty cost overblew, RR could've raised T&M prices separately to mitigate it. TotalCare removes this lever/safety valve. I do think business model matters.

 

- Tough regulations only concern safety, not maintenance cost/frequency.

 

- "RR has a pretty good handle on the costs involved in the maintenance of a jet engine." This I agree.

 

- "The risk is real but overstated." Possible. I just don't know how to handicap it. Hence, I said blackbox. In Taleb's lingo, TotalCare makes RR more "fragile", not less. How much more? I dunno.

[rb]

- Implied warranty has existed, yes. But in the old days, if warranty cost overblew, RR could've raised T&M prices separately to mitigate it. TotalCare removes this lever/safety valve. I do think business model matters.

 

- Tough regulations only concern safety, not maintenance cost/frequency.

 

- "RR has a pretty good handle on the costs involved in the maintenance of a jet engine." This I agree.

 

- "The risk is real but overstated." Possible. I just don't know how to handicap it. Hence, I said blackbox. In Taleb's lingo, TotalCare makes RR more "fragile", not less. How much more? I dunno.

Portfolio, I think you may be trying to create mountains out od molehills here.

 

First of all taleb was a guy that called a macro move right, I don't know why he should be an authority on jet engines.

 

Second of all, this uncertainty about costs is a bit unwarranted. Rolls engines are not new. They're all basically derivatives of the Trent engine. For different application you basically have a bigger fan or a smaller fan or lighter material for this blade or vane. Also these materials are not very new but pretty well tested.

 

Also back in the day you had quite a bit of after market for engine parts. Also back in the 90s there were a lot of fake parts that made their way into the supply chain. Total care contracts effectively take out this competition, not for Rolls but also for GE. Under these contracts they also have higher margins than before because they offer a cash flow smoothing for airlines. It also offers cash flow smoothing for the suppliers but it appears the appeal is greater for the airlines since they're willing to pay for it.

[portfolio14]

Portfolio, I think you may be trying to create mountains out od molehills here.

 

Thinking hard about the downside. Can't help. LOL.

 

First of all taleb was a guy that called a macro move right, I don't know why he should be an authority on jet engines.

 

Wow, this I completely disagree. We are talking about risk/epistemology, not macro or jet engine.

 

Second of all, this uncertainty about costs is a bit unwarranted. Rolls engines are not new. They're all basically derivatives of the Trent engine. For different application you basically have a bigger fan or a smaller fan or lighter material for this blade or vane. Also these materials are not very new but pretty well tested.

 

Have you watched the BBC documentary of Roll-Royce?

 

I agree in general the engine design changes within the Trent family is incremental. But the cutting-edgeness of these modern engines is nothing short of amazing. e.g. How can the combusion components withstand the the temperature higher than the melting point of its meterials?

 

Also back in the day you had quite a bit of after market for engine parts. Also back in the 90s there were a lot of fake parts that made their way into the supply chain. Total care contracts effectively take out this competition, not for Rolls but also for GE. Under these contracts they also have higher margins than before because they offer a cash flow smoothing for airlines. It also offers cash flow smoothing for the suppliers but it appears the appeal is greater for the airlines since they're willing to pay for it.

 

In the T&M days, airlines had to use genuine parts anyway in order not to void the warranties. Of course, warranty durations are shorter than TotalCare contracts. So, there is no doubt TotalCare fends off MRO competitors.

[rb]

Portfolio, I think you may be trying to create mountains out od molehills here.

 

Thinking hard about the downside. Can't help. LOL.

 

First of all taleb was a guy that called a macro move right, I don't know why he should be an authority on jet engines.

 

Wow, this I completely disagree. We are talking about risk/epistemology, not macro or jet engine.

 

Second of all, this uncertainty about costs is a bit unwarranted. Rolls engines are not new. They're all basically derivatives of the Trent engine. For different application you basically have a bigger fan or a smaller fan or lighter material for this blade or vane. Also these materials are not very new but pretty well tested.

 

Have you watched the BBC documentary of Roll-Royce?

 

I agree in general the engine design changes within the Trent family is incremental. But the cutting-edgeness of these modern engines is nothing short of amazing. e.g. How can the combusion components withstand the the temperature higher than the melting point of its meterials?

 

Also back in the day you had quite a bit of after market for engine parts. Also back in the 90s there were a lot of fake parts that made their way into the supply chain. Total care contracts effectively take out this competition, not for Rolls but also for GE. Under these contracts they also have higher margins than before because they offer a cash flow smoothing for airlines. It also offers cash flow smoothing for the suppliers but it appears the appeal is greater for the airlines since they're willing to pay for it.

 

In the T&M days, airlines had to use genuine parts anyway in order not to void the warranties. Of course, warranty durations are shorter than TotalCare contracts. So, there is no doubt TotalCare fends off MRO competitors.

There's also another aspect of total care the gets ignored a bit. That airlines can get performance tracking on the engines with total care. This goes a long way in predicting when parts will fail and so on. I don't have data on how much money is saved but there must be some cost savings (both for RR and airlines) in the fact that you can change or service a part before it actually breaks.

 

There's nothing wrong with thinking about the downside. I do that a lot too. I just don't think there's a ton of downside in the Total Care business. With Rolls I'm more concerned about their decision to lower inventory. The Sequoia guys love the decision, I don't. Rolls historically has had a problem with on time deliveries so them taking out inventory when they're about to have a big jump in production doesn't seem  like a very good idea. The penalties for late delivery could add up quickly.

[portfolio14]

rb,

 

Good discussions.

 

Another downside I'm worried about is whether they can ramp up the output to meet the demand. This comes before whether they can edge up their margins.

[Picasso]

Has anyone been able to source the Lone Pine short thesis?

[Phaceliacapital]

How long have they been short?

 

In other news:

 

Alan Tovey

    Sept. 10 (Telegraph) -- Rolls-Royce to build and maintain jet engines for Airbus's huge and ungainly Beluga XL transport planes

    Rolls-Royce has won a £500m ($700m) deal to supply and maintain the engines for Airbus’s new fleet of “Beluga” cargo jets.

    The airliner manufacturer uses the ungainly looking aircraft – named after the Beluga whale because its bloated upper fuselage means it bears a striking resemblance to the aquatic mammal – to transport large sections of new planes, such as entire wings.

    Rolls-Royce is being awarded the contract to power the five new aircraft with its bestselling Trent 700 engine. It is a victory for the Derby-based engineer, as Airbus’s current Beluga fleet use engines made by American rival GE.

    Bertrand George, an Airbus vice-president, said: “We look forward to the Trent 700 powering this important development in our air transport strategy. The engine has an excellent record on the A330 and is ideally suited to our requirements for this aircraft.”

    Simon Carlisle, Rolls-Royce executive vice-president, added:

“We welcome this decision to select an engine that is the clear market leader on the A330 and offers outstanding performance in terms of fuel burn, reliability, emissions and noise.”

    The design for Airbus’s new Beluga transporters will be based on the company’s A330 jet, which is larger than the older

A300 model from which the earlier Belugas were developed.

    The five new Beluga XL jets will be able to carry almost a third more cargo than the aircraft currently in service.

    They are needed by Airbus to cope with rising demand. The company is increasing production of its latest A350XWB aircraft and has a record order book approaching 7,000 jets.

    Airbus’s roots as a pan-European aircraft manufacturer means it has facilities located around the continent making major sections of aeroplanes. These are then brought together at final assembly plants in Toulouse, Hamburg and Tiajian in China. A new plant is currently being constructed in Mobile, Alabama.

    Belugas are a regular sight at Airbus’s plant in Broughton, North Wales, where the wings for all of the company’s airliners are manufactured. Airbus recently invested £21m in a new loading dock at the site so Belugas can take on board wings under cover.

    Previously, operations could only be carried out on relatively calm days because when the Belugas’ giant cargo doors were opened they acted as giant sails, making it operations dangerous if gusts touched 30 knots.

    The Trent 700 is Rolls-Royce’s most popular engine, with more than 1,500 in service. It has won 60pc of new orders in its class over the past three years and also powers 90pc of all A330 freighter aircraft.

    However, the Trent 700 has recently been a source of trouble for the company. In July the FTSE 100-listed business issued a profit warning, largely because sales of the engine are set to decline faster than the engineering group had forecast.

    Airbus is running down production of its A330 aircraft, which are powered by Rolls Trent 700 engines, ahead of the introduction of the new A330neo model with more efficient Rolls'

Trent 7000 engines.

    Accordingly, airlines are reluctant to buy the older jet with a new model waiting in the wings, so Airbus is scaling back production.

    But while Rolls had been forecasting a fall in the number of old-model A330s built and sold, the rate of decline has been greater than expected and means the market for its 700 engines and their servicing deals is also shrinking faster than forecast.

 

 

[Picasso]

They disclosed their short in July.

[KCLarkin]

Any theories on the 6% drop today?

[TheAiGuy]

No idea -- I've been looking for news but I haven't found anything.

 

More generally, I've been trying to dig up a bear case for this but the best I've come up with is the same that's on the board: engineering risk with future deliveries. 

[Phaceliacapital]

Market sentiment?

 

I only see news of new orders and layoffs, which are both good things.