I need to start this topic with stating that Rolls Royce is NOT a car company. The brand was sold to BMW and currently Rolls Royce is the company that is involved in a number of topics, but the main business is different types of engines mostly for aircrafts and ships.
In 2019 (pre-Covid) aircraft engines brought around 66% of company's revenues. Hence, as you can imagine, those revenues were butchered during 2020 and COVID-19 lockdowns (as air-travel was restricted) and the same takes place for the stock price. Check the chart below, company is currently trading on the multi-decade lows and the play here is to at least reach pre-covid levels, or even go higher (given the real options discussed later in the topic).
As usually in my prior topics - there are reasons why this stock is trading that low and as usual in my topics I will start with risks.
As a side note company is UK based, hence most of the numbers below will be in British pounds (GBP). Company is though traded in London and in US under tickers RR (in GBP) and RYCEY (in USD)
Reasons for low price and related risks.
1) Interestingly enough the company makes most of the revenues not when the engines are sold, but rather when the engines are maintained and used. In fact the company receives payments for number of hours when the engine was flying. Hence, non-recovery of international travel and further lockdowns is obviously a risk. If you believe in this - you should not invest in the "recovery" stocks I mostly talked in my previous posts and in this one.
2) Awful financials. Company obviously made a loss of 4 billion British pounds and burned 4.4 billions of cash. And this is despite cutting the costs of around 1 billion and cutting 7,000 employees. With the assumption of 55% of air travel recovering in 2021 the company will still be burning around 2 bn of cash, while holding 3.6 bn of cash as at 31 December 2020. so not only the recovery should happen, but for Rolls Royce it is important that the recovery takes place FAST. Otherwise company might face liquidity and bankruptcy issues.
3) As a way to get the liquidity (i.e. cash) for the company - the company was issuing shares and hence diluting the shareholders. This dilution started already from 2018, so the problems of the company indeed started already earlier and the company did not hesitate to dilute shareholders, i.e. transfer the cost of issues on them. Indeed the problems of the company started much earlier (overblown expenses, issues with some of the engines previously issued (search for Trent 1000 if interested). This risk for me is mitigated by the following 2 points though:
a) The stock price now is so low, that issuing new shares almost does not make sense. 1 thing is to issue 1 share with the price of 10 GBP and another with the price of 1 GBP. Indeed the company can just increase the amount of shares to be issued, but they will need to increase so many shares and sell them in the market that the price will drop even further and the dilution of shareholders will be so big that no one will touch this company again.
b) Company in general almost announced that further liquidity will be achieved not through shares issue, but rather through divestment of some unprofitable or low-profitable operations (around 2 bn is expected) and through further cost cutting and if needed additional debt. The company also appointed a new CFO in 2021 to accommodate.
4) As the company had previous issues with the engines (Trent 1000) - issues could come out with other engines or new products or competitors might take business away from RR. While this is trues there are few points that mitigate this risk:
a) Company is generally known as a high quality supplier (even back in history when this was a car company) The Trent 1000 issue based on prior history was a one-off problem with no other big failures. So historic data suggest we do not have a big problem
b) The market of creating engines for planes is highly regulated and has high entry costs. Thus, the entry for competition is very unlikely. There are current competitors (mostly General Electrics), but all the airline companies will not switch to engines of the RR competitor just due to the issues with 1 type of motors. This is just too risky. Imagine as an airline company you bought all the planes with GE motors and something is wrong with them - all of your planes are non-operational. While if you split 50/50 - your risk is managed at least a bit. It is a similar story to choosing Boeing or Airbus planes. Most airlines companies will have both types.
c) I am not planning to play this stock up to the ATH prices. We are just waiting to the return to the pre-covid levels. It is a more short/mid-term play, hence less risk of some new failures of new products, just because there is less time.
Bull case and positive points of the company
1) Around 20-30% of the company's revenues come from Defence sector (engines for US, UK and European Union military). With the world conflicts not stopping and in general due to stability of the contracts with government, this is an almost guaranteed revenue from RR. This gives some margin of safety for the company. This also makes this company very important for the western governments and they will just not let it go bankrupt. This almost fully covers the risk of bankruptcy of Rolls. The government will bail the company out, give her more contracts etc. As an illustration of this check this article: Norway blocks Rolls-Royce subsidiary sale on national security grounds - Industry Europe.
Norway basically stopped the sale of Rolls Royce subsidiary, as it was considered a threat for national security. Well in this case a default of Rolls Royce is also a national security question and it will not be allowed.
And look, there is now a big contract with US pending with regards to the change of the engines for the B-52 bombers. Maybe RR will get it, just because it is in quite a need for revenues: ‘Too early to say’ when B-52 engine contract will be awarded (defensenews.com)
2) Out of 4 billion loss in 2020, 1.9 billion were recorded as financial cost (compared to 225 million in 2019). The costs are mostly a one-off loss on hedging items that should not repeat. Let me explain. The company reports its financial statements in GBP, but receives a lot of revenues in USD. In order not to be exposed to much to the FX risk (GBP/USD exchange rates moving adversely), company uses derivatives. So if the USD is weak, company receives USD and receives additional gains from the derivative. If USD is strong - company receives USD and incur some losses on the derivative, so in the end the result is stable despite the FX movements. During the COVID crisis company was double hit by this hedging because:
a) Company did not receive any USD, as the business stopped.
b) during the big crisis all of the assets get sold for cash (check basically the prices of Gold, cryptocurrencies, stocks, bonds in March 2020 - all went down). As a result there is a very strong demand for cash, particularly the reserve currency of the world USD. Basically USD got as strong as it could be during the crisis. Hence, the company incurred big losses on derivatives without receiving any USD. UNLUCKY. The decision to hedge is a perfect risk management decision, but it turned out to be extremely bad in the extreme situation.
This is though a one-off expense, so next year even with this bad of a situation should have a better result. Moreover, check what happened with the DXY (dollar) index after the COVID crisis:
The dollar index went from 101.7 to 90.09 (dropped by 11%) lower than it was pre-covid. We are not sure whether any of the opened derivatives were still in action, but if yes, company could actually make a profit on derivative instruments in 2021. This would be a nice one-off and very welcomed gain.
3) COVID crisis actually forced company to review its costs. Operating costs were too high. The company (although has to eliminate 9,000 employees) has put the plan in place to cut 1.3 billion in costs. Imagine how inefficient the company was if it can operate with 9,000 less employees and 1 billion less in expenses. Now this is solved and if everything returns to 2019 terms, the company will be earning 1.3 billion more. 2019 results were 800 millions, so 163% more!! Huge upside potential.
Last 2 points I want to talk are what is called "Real options" in equity valuation techniques. Basically it is a possibility, but not an obligation of the company to take additional projects. And Rolls Royce has a LOT of them. Some of these projects are super interesting, although maybe more relevant for longer term shareholders. I am quite exited about them, so will put them in a separate sub-paragraph.
Real-options for Rolls Royce
1) I will start with what most exits me - Rolls Royce to enter the nuclear market. Talking about nuclear energy and uranium could be a topic for a separate write-up. If interested you can search for it, but in general the idea is that nuclear is the cleanest source of energy and we need it to meet our CO2 emission goals.
As you can see UK sees nuclear as clean energy and Rolls Royce, a UK based company has a solution:
Small modular reactors – Rolls-Royce
I actually think that this is the way to play nuclear energy topic. Majority of people do it through purchasing the uranium miners, i.e. by investing in uranium. I actually think that there is enough uranium and most of the production existing currently can just expand easily if there is demand. Playing this topic through new technology, specifically through small stations with low cost energy (cost to be comparable with offshore wind at around £50 per megawatt-hour) is the way to go.
The plan is though as follows, so it would be a 10-15 years investment: the first design to be assessed by regulators in the second half of 2021 in the newly-opened assessment window, which will keep it on track to complete its first unit in the early 2030s and build up to 10 by 2035.
In the UK alone the power station programme is forecast to:
create 40,000 regional UK jobs by 2050
generate £52 billion of economic benefit
have 80% of the plant’s components sourced from the UK
target an additional £250 billion of exports – memoranda of understanding are already in place with Estonia, Turkey and the Czech Republic
cost initially c.£2.2bn per unit dropping to £1.8bn by the time five have been completed
operate for at least 60 years
The design, which will be finalised at the end of the regulatory assessment process, proposes that all used fuel will be stored on each site for the lifetime of the plant.
2) Space tourism
Space tourism could be the next big thing where companies involved could make a lot of money with high margins. Obviously the first idea is to play this through Virgin Galactics (SPCE). What I do not like is that it is a risky play in the sense that if the testings do not go successfully, the company will die and it has no revenues currently. Well SPCE signed an agreement with Rolls Royce to design the engines for supersonic aircraft: Virgin Galactic Partners With Rolls-Royce and Unveils Supersonic Aircraft Design | The Motley Fool
Rolls Royce has already experience in this area, as Rolls Royce engines were used on Concorde jets. Although Concorde strory did not end well, the problem of the planes were not with their engines.
Moreover rolls Royce has collaboration with other partners: Boom and Rolls-Royce announce collaboration to advance Overture program | by Boom Supersonic | Boom Supersonic
So if it does not work for SPCE - could work for someone else, but Rolls Royce is always involved.
This later on will be also used for military equipment, so another source of income.
3) Clean energy.
there are a lot of other developments for today's trendy green energy topics where Rolls Royce could have some great ideas:
Electric aircrafts: ACCEL – the world’s fastest electric plane – Rolls-Royce
Fuel cells: Our stories - Fuel cells and the quest for green drive power and powergen technology –Rolls-Royce
Hybrid jet engines, sustainable fuel, etc. Just visit their website. Each of those can be huge.
Price targets and entry point
with regards to the entry point, I have bought an initial position at a price of around 1.5 USD, it is now trading higher with a recent increase (this increase actually pushed me to write the topic). I was postponing, as normally this was a slow mover, but started to pic up pace these last days. Anyway, you are not late for the trade.
With regards to the price target. The pre-pandemic stock price was around 9 USD per share. Obviously the company issued additional shares (there was a 77% dilution), this would give a price of 2.07 USD.
But less us not forget that company eliminated 1.3 billion of costs, that would increase its profits (2019) for more than 168%. Assuming the same P/E ratio as in 2019, we would get the price of 2.07*168% = 3,48 USD. This is more than 2X from here and this is a short-term target for the return to 2019 without any additional news.
On top of this, we discussed about possible new contracts with governments, flying can rebound stronger than to 2019 levels due to the pent-up demand. Any of the "real options" discussed above could be a game changer.
This is a play with a smaller conviction than my prior ideas published, but still a trade where no one is late. Check the stock prices of airline companies - they are already priced as if flying is returning back. I think airlines come first to mind of people who think about reopening of borders and economy. Engines from planes are far harder to thing of + rarely people know that engine companies get paid per hour of flight, not just per engine - hence this suggested trade is far less crowded and shares can be still bought cheap. This will though not last long.
