Rolls-Royce: The Industrial GARP Play Of The UK

seekingalpha09-17

Rolls-Royce shares have surged to an all-time high of £5.00, driven by a sharp and sustained rebound in its Civil Aerospace business, in 2023.FCF over the coming 2-3 years is expected to fall between ...

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Michael Derrer Fuchs/iStock Editorial via Getty Images Introduction For holders, Rolls-Royce (OTCPK:RYCEY) is the gift that keeps on giving as shares hit another yet another all-time high around £5.00 per share. After a difficult period during the pandemic, Rolls-Royce aero engine business, which is tied to engine flying hours via Long-term Service Agreements (LTSA), saw a sharp rebound as wide-body flying hours recovered in 2023. This is known as its \"Civil Aerospace\" business which accounts for over 50% of group revenue, wide-body engines make up 68% of this business. Additionally, Rolls-Royce's other business units - Defense and Power Systems, are also seeing an increase in demand. From the lows 2 years ago when the market cap was trading sideways around £10bn, the valuation has increased 300% to around £42bn today. Tikr Terminal  Regardless of the increase in valuation, based on future earnings, does Rolls-Royce provide an attractive entry point for investors at a £42bn valuation? Valuation Seems Fairly Priced We value businesses on free cashflow (FCF) as this represents the tangible cash that flows into the company. This money can be used for buybacks, dividends, M&A etc. Based on the sell-side consensus estimates, FCF is expected to be between £2.5 - £3.3bn in the next 2-3 years. Bloomberg Terminal At the current market cap of £42bn, this would present a FCF yield between 6% and 8.5% forward 2-3 years. The chart below shows the trailing FCF yield for Rolls-Royce, excluding covid, historically trades above 4% but below 10%. Within a few years, the company FCF could be closer to the higher bound and still increasing at a time when interest rates are likely lower in 2027. Bloomberg Terminal Therefore, I'd argue Rolls-Royce's valuation isn't too exuberant, but this isn't too attractive for younger investors looking to maximize returns. On the FCF guidance given at HY2024, the current FCF yield in FY24 would be 5.11% thus there's also a case for existing shareholders to stay put to see how the dividend evolves. The current policy is to distribute 30% (potentially increasing to 40%) of underlying profit after tax to the shareholder via dividends. RR H1 Results Even for older investors looking for stability and a growing dividend (which has been reinstated for payment in 2025) Rolls-Royce still isn't attractive unless you're an existing investor who bought over the course of 2020-2023. I'd argue Rolls-Royce's valuation trades around its 'fair value' based on everything we know about the company and its financial prospects. Future Appears Positive for Civil Aerospace The recent Boeing (BA) workers strike, which includes the Seattle Everett Factory where the 787 Dreamliner is assembled means Rolls-Royce's 1000 engines could see a slight slowdown in deliveries. Production at the other 787 factory in South Carolina continues as normal and is not likely to see strike action as employees in North Chesterton are non-union. The strike action is an insignificant event for investors because Rolls-Royce's Civil Aerospace business generates the majority of profit from LTSA's contracts rather than new engine sales. Furthermore, the rest of Rolls-Royce's wide body engines including key engines; Trent 7000, Trent XWB-84, Trent XWB-97 continue to delivered to Airbus for their wide-body models. RR H1 Results Rolls-Royce's engine fleet continues to expand at a steady rate and the Trent 1000 only has 58 engines outstanding for Boeing's 787. As more engines are delivered more potential revenue can be captured via more flying hours across Rolls-Royce's engine fleet. RR H1 Results Additionally, business aviation equipment revenue has picked up, resulting in a 119% increase in H1 2024 revenue compared to the same period last year, and service revenue for this segment increased 38%. Rolls-Royce's large engine flying hours are expected to be equal to or greater than 2019 levels in FY24. However, as flying volume recovers, pricing will be much higher than 2019 levels as LTSA's include inflation related price mechanisms. Rolls-Royce next-gen turbofan engine, the UltraFan is reported to be 25% more fuel efficient than the first generation Trent engine. Compared to the Trent-XWB engine Rolls-Royce say the UltraFan is 10% more fuel efficient, which is a justification of development efforts for next-gen wide body planes from Airbus and Boeing. The UltraFan is in R&D and is expected to have a 200k horsepower gear box engine with far less noise pollution. The UltraFan project will hopefully be used for Airbus and Boeing new wide-body iterations that could go into production in the 2030s. Briefly looking at Defense and Power Systems, these units are also guided to grow YoY around mid-single digits in FY24 and FY25. Bloomberg Terminal The Defense business is fairly diversified across submarines, aircraft, helicopters, weapons systems, transport etc. It's hard to analyze the defense unit, but due to increased geopolitical tensions and the ongoing war in Ukraine, global defense spending in 2023 increased at the fastest pace since 2009. This trend is expected to continue with several western governments voicing bigger defense budgets, including the UK government, which under Rishi Sunak, committed to a 2.5% of GDP Defense budget by 2030 (nominal expected to be £87bn in 2030). As for power systems (22% of H1 sales), they saw an 11% increase in backlog primarily driven from data center demand, which can be seen as a continuing trend looking at CapEx from hyperscalers GCP, Azure, AWS, Oracle Cloud etc. ABI expects the number of data centers to reach 7,000+ globally by 2030, up from the 5,180 expected at the end of 2024. The Power Systems unit also sells into marine and government, which is hard to find information on due to the restricted classification of those programs. But in summary, the various units seem to be on a positive trajectory, with Rolls-Royce reporting decent book-to-bill ratios in H1; - Civil Aerospace - 2.3x (strong order demand vs. what's being not delivered) - Defense - 0.8x (deliveries slightly outpacing orders) - Power Systems 1.3x (orders slightly outpacing deliveries) Conclusion Rolls-Royce is a hard company to pinpoint with many different moving parts demonstrating a reliance on key aircraft OEMs, wide-body/private aviation flying activity, government infrastructure & military spending. Rolls-Royce remains somewhat diversified but is mostly exposed to flying hours on their wide-body engine fleet. Regardless of the positives addressed, the point of this article was more a focus on valuation and if Rolls-Royce's reversal in investor sentiment over the past year resulted in a overvaluation. I would argue Rolls-Royce's valuation appears efficient and doesn't offer investors an attractive proposal as the \"£2-3bn operating income\" guidance is dwarfed by the current £42bn valuation, which is why I suggest a \"Hold\" rating.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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