Rolls Royce

DETTA INLÄGG ÄR ETT UTDRAG UR KVARTALSBREVET JAG SKICKADE TILL PANDIUMS ANDELSÄGARE 30 OKTOBER 2015.

Rolls Royce (RR) makes engines to the aerospace, marine and industrial markets. (The namesake car manufacturer is a separate company owned by BMW.) RR has two divisions: one selling jet engines and services to civil and defence aerospace customers and another selling engines and power solutions to marine and industrial customers. The aerospace business is the most important, representing c. 75% of profits. 

Selling jet engines is an interesting business, in some ways similar to selling razors. When you buy a Gillette razor they are very cheap. It is when you need razor blades that it starts to cost you.  The benefit for Gillette is that once you have decided to use their razor they will sell you all the blades since no one else is allowed to. RR does the same but with jet engines. They sell the engines cheap, so cheap that they actually loose money doing it. But then they add a service contract to the deal that lasts for 10-15 years. The services and spare parts revenues on an engine are more than four times bigger than the price of the engine. Profits in the aftermarket are high and makes up the initial loss many times over. 

RR recently appointed Warren East as CEO. This is great because the previous CEO was not very good and Warren seems to be. During his 12-year tenure as CEO of ARM (a competitor to Intel) he increased the earnings per share with 15% per year. That said ARM did benefit from the tremendous growth of the smartphone market where they became a leading supplier, so there was a component of luck. But as Ingemar Stenmark used to say: “the more I train, the more lucky I seem to get”. Besides being a good operator Warren was a great capital allocator during his years at ARM, and that is equally important. 

What did we pay for this gem then? Not much. We paid around 10 times operating profit for a company that will, based on the current order book, double its profit the next five years. RR deserves (and has historically had) a higher multiple. As an additional upside, it is not unlikely that the new management might increase the margins of the business a couple of percentage points. General Electric, RR's largest competitor, has double the margins and there are several simple things that RR could do to catch up with them. 

I see limited risk of us losing any money in this investment. It is a conservatively financed company with a clear growth path. If the worst would happen and an external event would lead to large order cancellations RR will still grow revenue. Even a highly unlikely 50% cancellation rate should give us a return that is higher what we can expect in the general stock market.

RR is a great example of the market's short-sightedness and Pandium's edge in being able to invest long-term. We know that the company will sell around 4,000 engines the next ten years and that most of those engines will give RR a long valuable service contract. Although this is publicly available information, the market has reacted to a couple of short-term profit warnings as if the RR model is broken. So despite the fact that RR's future has never looked brighter the stock has gone from GBP 12.70 to GBP 7.00. Just by being one of few investors that care more about the earnings five years from now than this year’s we are able to buy this high quality company at a bargain price.