After Earnings, is Rolls Royce a Buy, a Sell, or a Hold?

The
company
was
also
boosted
by
an
increase
in
its
civil
aerospace
operating
margin,
which
reached
11.6%
in
2023
versus
2.5%
in
2022,
on
the
back
of
higher
percentage
of
spare-part
sales,
increased
time
on
wing
benefiting
long-term
service-agreement
contracts,
price
optimisation,
and
cost
efficiencies. 

Subsequently,
Morningstar
increased
its
fair
value
estimate
from
£289
to
£380
because
of
an
increased
confidence
in
the
firm’s
civil
performance
delivery.  

Key
Morningstar
Metrics
for
Rolls
Royce  

Fair
Value
Estimate:
£380
Morningstar
Rating: ★★★
Morningstar
Economic
Moat
Rating:
Narrow
Morningstar
Uncertainty
Rating:
High

Rolls
Royce
Stock
Price 

For
Loredana
Muharremi,
equity
analyst
at
Morningstar,
Rolls
Royce’s
160%
share
price
growth
can
be
attributed
to
a
corporate
restructure.

Since
2016
the
company’s
return
on
invested
capital
has
been
below
the
weighted
cost
of
capital.
The
business
also
faced
challenges
before
the
pandemic
due
to
issues
with
its
Trent
1000
engine
and
because
of
poor
capital
allocation
decisions.
 

For
Muharremi,
one
of
Rolls-Royce’s
most
significant
strategic
errors
was
exiting
its
exposure
to
the
narrow-body
aircraft
market
in
2012,
when
it
sold
its
37.5%
stake
in
International
Aero
Engines,
a
joint
venture
to
produce
the
V2500
engine.
 

“Between
2008
and
2017,
Rolls-Royce
focused
on
investing
heavily
in
building
market
share
by
developing
seven
new
engines
and
ramping
up
industrial
capacity
with
investments
in
R&D
reaching
10%
of
revenue,
versus
6%
of
peers
exposed
to
growing
narrow-body
market,
without
a
clear
path
from
management
on
how
to
recover
the
investments
given
the
shrinking
market
share
of
wide-body
aircraft,”
she
says.
 

However,
with
the
appointment
of
Warren
East
as
chief
executive
in
2015
(he
stepped
down
at
the
end
of
2022),
change
was
afoot.
That
included
disposing
of
non-core
assets. 

“The
Covid-19
pandemic
and
its
impact
on
wide-body
aircraft
demand
further
deepened
Rolls-Royce’s
restructuring
program,
resulting
in
£1.3
billion
in
structural
annual
cost
savings
through
measures
such
as
job
cuts
and
production
site
consolidation,”
she
says.

“This
restructuring
effort
included
shedding
9,000
jobs,
which
represents
about
30%
of
the
civil
aerospace
segment’s
workforce.”  

Muharremi
also
notes
that
Rolls
Royce
reduced
its
targeted
R&D
spend
to
5%
of
sales,
to
shift
the
focus
away
from
the
current
fleet
to
next
generation
engines
and
low-carbon
alternatives.
 

“We
believe
the
restructuring
as
well
as
the
new
R&D
target
spending
and
mix
were
necessary
to
align
the
group
with
the
lower
demand
outlook
over
the
medium
term
for
its
suite
of
wide-body
engines,”
she
says.

“Moreover,
the
company
used
the
Covid-19
time
to
focus
on
increasing
engines
performance
in
terms
of
durability
(extending
time
on
wing
)
and
reliability,
solving
most
of
the
thrust
issues
that
the
engines
presented.” 

Why
Has
Rolls
Royce’s
Fair
Value
Estimate
Increased?

Muharremi
argues
the
Fair
Value
Estimate
for
Rolls
Royce
has
bumped
up
because
its
commercial
performance
exceeded
expectations.
 

“The
company
delivered
already
40%
of
the
expected
mid-term
performance
improvements
(time
on
wing
extension
and
increased
reliability)
ahead
of
schedule,”
she
explains.

“On
the
back
of
its
improved
engine
performance
the
company
exceeded
our
expectation
in
terms
of
commercial
performance
as
it
was
able
to
negotiate
higher
pricing
than
expected
on
new
contracts
and
existing
RPFH
contracts
that
were
up
for
renewal. 

“Recovery
in
demand
for
both
OEM
and
aftermarket
from
Covid-19
levels,
with
the
high
margin
aftermarket
business
recovering
ahead
of
ASKs
due
to
pent-up
demand,
lower
cost
structure
(explained
above),
and
increased
engine
performance.”

Rolls
Royce
has
90%
of
its
fleet
signed
with
long-term
revenue
per-flying
hours
(RPFH)
contracts,
so
engine
performance
improvements
drove
higher
RPFH
profitability.

This
also
allowed
the
business
to
negotiate
for
higher
prices.
In
light
of
this,
Muharremi
expects
price
increases
to
continue
as
the
company
continues
delivering
on
engine
performance
and
the
mix
shifts
towards
more
profitable
new
RPFH
contracts. 

Economic
Moat
Rating 

Muharremi
assigns
the
business
a

Narrow
Economic
Moat
because
of
its
intangible
assets,
its
technical
know-how
and
engineering
expertise
across
the
civil
aerospace
and
defence
segments
of
the
company.
 

The
civil
aerospace
division
generated
48%
of
total
revenue
in
2023,
with
70%
from
large
engines,
and
28%
from
business
aviation
and
regional
sectors.
As
a
sector
it
has
high
entry
barriers,
ranging
from
stringent
regulatory
requirements
to
rigorous
safety,
reliability,
and
durability
qualification
processes.
 

Only
four
companies,
including
Rolls-Royce,
have
the
technological
expertise
and
capacity
to
design,
manufacture,
and
service
large
commercial
aircraft
engines. 

“The production
of
engines
requires
significant
capital
upfront,
extensive
research
and
development
investments,
and
skilled
workforce,”
she
says.

“Rolls-Royce
employs
a
large
team
of
skilled
engineers
and
invested
up
to
around
10%
of
its
revenue
in
research
and
development
from
2010-17,
resulting
in
1,994
patents.
The
civil
aerospace
industry
should
realise
a
recovery
as
RPK,
or
revenue
passenger
kilometres,
increases
following
the
covid
pandemic”.

Muharremi
has
also
assigned
Rolls
Royce a
narrow
moat
because
of
its defence
business.
Its
program
wins
in
the
defence
sector
are
typically
long
term,
creating
high
barriers
to
entry
and
fostering
intense
competition
among
established
players
for
new
opportunities.
Within
the
defence
business,
services
contribute
to
54%
of
total
revenue.
 

“Unlike
the
commercial
aerospace
sector,
the
defence
sector
faces
challenges
in
centralising
maintenance
due
to
the
greater
geographical
dispersion
of
customer
assets,”
she
says.

“Consequently,
attachment
rates
of
long-term
service
contracts
are
low,
at
around
30%.”

As
a
result,
Muharremi
believes
that
most
of
the
service-related
revenue
comes
from
the
sale
of
spare
parts
to
a
fragmented
base
of
third-party
service
contractors.
 

“While
the
fleet
of
16,000
in-service
engines
globally
generates
high-margin
revenue,
the
MRO
defence
segment
does
not
benefit
from
significant
switching
costs
due
to
the
low
attachment
rates,”
Muharremi
adds. 

Risk
and
Uncertainty 

However,
Morningstar
has
given
Rolls-Royce
a

High
Uncertainty
Rating
because
of
the inherent
cyclicality
of
the
aerospace
industry,
links
to
the
global
economy,
and
uncertainty
based
on
concentration
risk
on
wide
bodies’
outlook. 

According
to
Muharremi,
Rolls-Royce’s
business
is
exposed
to
high
cyclicality
as
approximately
45%
of
the
company’s
adjusted
consolidated
revenue
and
34%
of
EBITDA
comes
from
civil
aerospace
activities.
 

“As
well
as
airlines’
profitability
being
closely
tied
to
factors
like
global
economic
growth,
and
oil
prices.
A
downturn
in
these
factors
might
lead
to
airlines
tightening
their
budgets,
reducing
orders,
or
postponing
maintenance,
all
of
which
could
harm
it,”
she
says. 

Yet
she
remains
confident
that
Rolls-Royce
will
recover
in
the
medium
term
because
the
impact
of
each
economic
downturn
cycle
on
aircraft
deliveries
has
been
shorter
and
less
intense
than
previous
ones.
RPK
has
also
consistently
exceeded
gross
domestic
product
growth.
 

“The
risk
of
wide-body
aircraft
weaker
than
forecast
demand
due
to
order
cancellations,
early
retirements
and
reduced
flight
hours
will
negatively
affect
the
in-service
fleet
size
and
aftermarket
margins,”
she
says.

“Cost
inflation
and
supply
chain
challenges,
exacerbated
by
the
war
in
Ukraine,
could
potentially
affect
delivery
rates
and
margins
in
the
short
term.”

However,
Muharremi
believes
that
Rolls-Royce,
with
its
large
and
young
in-service
fleet
and
proven
ability
to
deliver
operational
efficiencies,
should
be
able
to
remain
profitable,
though
it
may
face
a
difficult
short-term
period
ahead. 

Bulls
Say 

•
Losses
from
new
engine
deliveries
will
decrease
as
Trent
production
ramps
up;
• High-margin
service
revenue
can
be
expected
to
jump
as
in-service
fleet
grows;
• A
leaner
and
more
focused
business
will
emerge
from
the
corporate
restructure.

Bears
Say 

•
Rolls-Royce
faces
a
highly
uncertain
recovery
from
Covid-19;
• Structural
demand
shifts
favouring
narrow-body
aircraft
could
have
a
negative
impact;
• Customers
are
growing
concerned
over
the
firm’s
ability
to
honour
long-term
contracts.

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