Two minute speech: Rolls-Royce

This blog was conceived in a three week stint in a quarantine hotel in Hong Kong. 

Throughout my trip to Hong Kong, my return flight to London was cancelled and rearranged with an irritating frequency. This was due to Hong Kong's strict quarantine regime which meant that many airlines were either banned from flying to Hong Kong, or like British Airways stopped all flights in and out of the territory altogether, or like Cathay Pacific simply didn't have the pilots.

Whilst most people would freak out in that situation (and, after spending a total of 12 hours on the phone to airlines, insurers and frustrated people in the UK wondering whether I would come home, I was close), I also wondered whether the ongoing disruption to the travel sector could translate to bargains in the stock market. I thought Rolls-Royce Holdings plc could offer such a bargain.

Rolls-Royce

RR's price/earnings (PE) ratio piqued my interest, it was stupendously low at 2.68. Scratching under the surface, I was interested in the fact that it provided something that airlines need to fly - engines. At the core of RR's civil aviation business is aircraft servicing. Basically, RR sells engines at a loss to aircraft manufacturers and the airlines/manufacturers pay RR to regularly service those engines.

PE ratio: 2.68.

Category: Turnaround. On first glance I thought that RR was a cyclical because it operates in two cyclical industries - civil aviation and defence. However, on reading Peter Lynch's criteria for a cyclical I wasn't so sure. RR is falling on hard times - it has been making losses for all but one year (2017) in the period of 2016 to 2020 and the airline industry (RR's customers) was badly affected during the pandemic. According to Peter Lynch, cyclicals are counterintuitive in that the PE ratio at the bottom of the market (the ideal time to buy) would be very high and at the top of the market the PE ratio would be very low. RR's PE ratio is less than 3 which is incredibly low.

Tell me about the market the company operates in

RR has three main businesses: civil aviation, defence/aerospace and power systems. Of these, RR's main breadwinner is civil aviation which, in June 2021 accounted for just over 41% of its underlying revenue (down from 53% in 2019). 

RR also has defence (at just under 33% of its underlying revenue) and power systems (at around 23% of its underlying revenue) divisions.

RR's civil aviation division is in difficult times as air travel has been greatly reduced by the covid pandemic. This is made worse by the fact that RR's civil aviation division sells engines at a loss and makes its money from the maintenance of those engines. Aircraft engines are serviced after a certain number of flying hours which clearly, mean that the planes need to fly for RR to make money. Furthermore, RR's engines propel aircraft that fly long haul sectors - Boeing 747, 777 and 787 and Airbus A350 and A380. 

Key countries (which are sources of businessmen and tourists and are key business centres and tourist destinations) continue to pursue a zero-covid strategy. 

China, Singapore, Malaysia, Hong Kong, Taiwan (ROC), Indonesia, Japan, Thailand, India, Vietnam, Australia, New Zealand and South Korea all continue to have restrictions on who can enter and have quarantine requirements with varying levels of strictness, even where a passenger is vaccinated. These countries are popular for long haul flights from Europe and North America and even within Asia-Pacific.

This means that travel within the Asia-Pacific region and between Asia-Pacific and Europe and the Americas is still greatly depressed. As a result, as of December 2021, RR's large engine flying hours were still at about 50% of 2019 levels.

This fact poses a risk as some countries are doubling down on the zero-covid strategy, like Hong Kong and the PRC. Others are opening up, but slowly, like Singapore and Australia. This means that flights to and from, and within these regions, will still be greatly reduced even as more countries in this slowly open up.

This has been shown as the airlines that service these regions have been greatly affected. Cathay Pacific, for example, is currently operating with a passenger capacity of 93% below pre-pandemic levels.

Airlines will need to find ways of cutting costs and this was evident when my other half recently flew with Cathay Pacific who, for instance, only offered one in-flight meal option rather than two or three. 

This cost-cutting, however, should not affect RR because airlines need engines to fly their planes and those engines need to be serviced. 

There is no way of getting around this reality and the fact that routes to, from and within Asia-Pacific will fly planes with RR's engines should provide an opportunity for RR to profit.

How is RR turning around? And can it succeed in its turnaround?

Can RR survive a raid by its creditors? I think it can. 

At its half year results in June 2021, RR had current assets of £13.2bn current liabilities of just over £11bn. This means that RR is able to pay its liabilities as they fall due. RR is cashflow solvent. The difficulty is that it is not balance sheet solvent - its total assets are around £28.8bn and its total liabilities are just under £33.4bn.

Looking at RR's long term liabilities, RR has increased its borrowing from just under £6.1bn in December 2020 to almost £7.7bn in June 2021. This is due to RR drawing down a £2bn loan maturing in 2025 which has been backed by an 80% guarantee from UK Export Finance (the UK Government's export credit agency).

This level of debt is something that concerns me, particularly the loan that is guaranteed by UKEF.

In terms of its wider debt structure, it has borrowed and repaid £300m in commercial paper issued by the UK government (which is good) and has issued just under £4.1bn in loan notes to noteholders. 

Peter Lynch divides debt into good debt and bad debt. Good debt is typically in the form of bonds (also known as loan notes). This is because those notes typically cannot be called in by the noteholders provided that the issuer can make the relevant repayments. 

Bank loans and commercial paper on the other hand are bad forms of debt for an investor because they can be called in on demand and the terms can be more restrictive (eg the UKEF backed loan prevents RR paying out dividends until the end of 2022 and until 2025 only allows dividends to be paid if certain KPIs are met - again this is another negative of purchasing shares in RR). 

Also, bank loans can often be made with reference to a floating rate of interest (ie base rate or SONIA plus a fixed percentage) whereas RR's notes accrue interest at a fixed rate. This means that, should interest rates rise (considering rising inflation, this is a distinct possibility) the fixed rate of interest on the notes that RR has issued will not rise meaning that RR will not have to pay increased rates of interest.

One positive is the fact that RR has more current assets than current liabilities and it has the benefit of the £2bn from UKEF-backed loan means that RR has the time to turn its position around and survive a raid by its creditors. 

RR has been turning itself around by restructuring its business. This restructuring has included 9,000 job losses in its badly affected civil aviation division which should save RR £1.3bn by the end of 2022. Also RR is selling off assets such as ITP Aero (which lost €13m in 2020) Bergen Engines (raising €91m together with a further €16m in cash that was held in Bergen), Civil Instrumentation & Control (from its loss making power systems division) to raise a total of £2bn. Also, other divisions of RR (such as its defence department) have signed lucrative defence contracts (outlined above).

RR has also had success in other parts of its business and has, for instance, signed lucrative contracts to the US Navy, Royal Navy and Royal Australian Navy with the propulsion systems for their nuclear submarines (helped by Australia, the UK and US signing the AUKUS treaty).

This seems to be making a difference to RR's fortunes. RR has announced that it is making cost savings more quickly than expected and it has already shed 8,500 (of 9,000) jobs. Looking at its mid year results in June 2021, it is starting to make a profit compared to the same period in 2020.

Further, with global travel routes reopening (particularly transatlantic routes between Europe and the Americas), larger planes which use RR engines will start increasing their flying ours meaning that airlines will require RR to service the engines.

What are insiders doing? 

Insiders are adding to their holdings in RR including a market purchase by the Chair of RR in December 2021 (a good sign) and other directors adding to their holdings through compensation schemes.

Verdict

I am cautious about this because of the amount of debt that RR has to service which may, over the next 3 years, act as a drag on revenues. The fact that Asia has not opened up (particularly China and Hong Kong) also makes me cautious due to the lack of flying hours of RR engines and, therefore, the lack of opportunity for RR to generate revenue by servicing those engines. If I were to buy the stock, I will also not receive a dividend until at least the end of the year and for the next three years there could well be higher interest rates to pay on RR's UKEF-backed debt.

That said, the transatlantic routes have come back and some countries in Asia (eg Singapore) are slowly starting to open up which provide opportunities for RR engines to fly. This provides a huge opportunity for growth and a PE of 2.68 makes RR seem like an exciting bargain. 

This is a risk but I will buy RR.