Rolls-Royce's Strong Performance Improvements Fuel Our Fair Value Estimate Increase

Equity Analyst

Loredana Muharremi

Rolls-Royce holds a prominent position in the global commercial and military aerospace propulsion and power system sectors. Its commercial aerospace segment generates approximately 50% of group sales, and the company is a market leader with a dominant 58% market share in wide-body aircraft engines.

The pandemic had a severe impact on the aerospace industry, with about 50% of flights grounded, leading airlines to focus on cost reduction by deferring orders and pushing aftermarket activity to preserve cash. In response, Rolls-Royce implemented a cost-restructuring program that yielded GBP 1.3 billion in annualized cost savings. Additionally, it conducted a GBP 2 billion rights issue and divested assets to raise an additional GBP 2 billion.

Rolls-Royce faced challenges even before the pandemic due to issues with its Trent 1000 engine. However, during this time, the company proactively addressed many of the engine's durability issues, solving seven out of nine, with the last two fixes planned for implementation this year.

The industry has shown considerable resilience as we observe a consistent recovery in available seat kilometers, also known as ASK, demand, primarily driven by leisure travel and China’s reopening. While narrow-body aircraft demand is leading the recovery, signs of improvement are also observed in the wide-body segment, albeit at a slower rate. We project about 5,000 total wide-body deliveries from 2022-35, with Rolls-Royce expected to capture approximately 2,700 new deliveries as it powers all four new wide-body aircraft in service, with three sole-source positions with Airbus.

In the aftermarket business, we expect Rolls-Royce spare parts sales and maintenance, repair, and overhaul or MRO, services, to recover ahead of ASKs until 2025 due to pent-up demand. 

Despite potential headwinds in 2024, like weaker economic growth in Europe and the U.S., persistent input cost inflation, and supply chain challenges, we are confident about longer-term outlook given the company’s stronger balance sheet, leaner cost base, performance improvements, and its large and young fleet ensuring continued demand for MRO services well beyond the next decade.

Business Strategy & Outlook

We assign a narrow moat to Rolls-Royce as a result of the presence of intangible assets in the form of technical know-how and engineering expertise in the civil aerospace and defense segment, and high switching costs present in the civil aerospace segment. We do not believe that the power segment has a moat source.

Civil Aerospace

Rolls-Royce's civil aerospace division generated 48% of total revenue in 2023, with 70% from large engines, and 28% from business aviation and regional sectors. It contains both OEM subsegment (37% of total aerospace revenues) and MRO (63% of total aerospace segment).

The civil aerospace segment 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. 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 realize a recovery as RPK, or revenue passenger kilometers, increases following the covid pandemic. Narrow-body aircraft demand will lead the recovery, with an estimated 26,000 deliveries from 2022-35, driven by increased demand for point-to-point travel, extended range capabilities of smaller aircraft, and the superior fuel efficiency of narrow-body planes for shorter hauls. 

Rolls-Royce withdrew from the narrow-body market in 2012 when it sold its stake in International Aero Engines, a joint venture focused on developing engines for this market. Instead, Rolls-Royce shifted its attention to manufacturing engines for wide-body aircraft, with a commanding 58% market share on current large engines.

We are seeing signs of recovery in the wide-body as well, even if at a lower rate. In 2023, Rolls-Royce’s large engine flying hours, or EFH, recovered to 88% of 2019 levels, a solid improvement from 48% in 2021. Following China’s reopening, we expect wide-body recovery to 2019 level by 2024. 

We project approximately 5,000 total wide-body deliveries from 2022-35. Among the wide-body aircraft, we expect the Boeing 787 to stand out as a potential winner, accounting for around 1,900 deliveries, thanks to its range and fuel efficiency performances, making it a sought-after option for long-haul flights.

Rolls-Royce engines power the majority of wide-body aircraft in service, supplying four out of five engines and being the sole source for the A350 family and for the A330neo, and 35% market share in the Boeing 787 fleet. Given its market position, we expect Rolls-Royce to capture around 2,700 new deliveries of the 5,000 total deliveries from 2022 to 2035. 

As of 2023, the company had approximately 1,700 engines on order and an annualized installed production capacity of 300 engines versus 600 engines in 2020 as it adjusted production capacity to the lower demand environment.

The slow recovery in the civil aerospace segment is a challenge for the company, but the new deliveries coupled with a young in-service fleet of more than 4000 aircraft will provide profitability support for the next 10 years through shop visits and service income.

The delivery of new engines initially affects operating profits negatively, and even at a mature stage, they generate low margins with break-even that tends to be 10-12 years into lifecycle. In order to lock in customers, original equipment manufacturers sell their engines with discounts as high as around 70%-80% of their list price.

The business model leans heavily on after-sales services, which yield high margins. When the company wins an aircraft program, it establishes a valuable and long-lasting revenue stream that can span several decades, considering the average retirement age of commercial aircraft is around 25 years. 

We expect Rolls-Royce's aftermarket business to play a crucial role in generating recurring revenue and profit margins as the company benefits from the long lifecycles of its engines, evidenced by the average age of its Trent 700 legacy large engines being 13 years, which still have over 40% of remaining EFH. 

We believe that Trent 700 engines will drive aftermarket revenue until 2025, and then be substituted by shop visits for the newer generation large engines, such as the Trent 1000/7000 and XWB-84/97, which have an average age of 4 years and 90% remaining EFH. 

The majority of the MRO profitability comes from the sales of spare parts during the first two major overhaul. Engines have their first overhaul after seven years (performance restoration- chemically treating the components and parts replacement) and the second overhaul is after 15 years (engine is completely dissembled and many components are changed, the result is almost a new engine). As of 2022 more than 52% of Rolls-Royce engines in service fleet have not undergone the first heavy shop visit yet, and 64% haven’t undergone the second one.

Rolls-Royce was the first to introduce full-service flight hour contracts, of typical durations of 10-15 years, through its TotalCare package, which has become the industry standard. In 2023, approximately 90% of Rolls-Royce's in-service fleet of more than 4,000 engines are signed with the TotalCare package, compared with a 10% attachment rate in 2000.

These contracts shift the business model from spare parts sales to a wider range of service contracts based on rate per flight hours, or RPFH. This transition provides advantages for both Rolls-Royce and airlines, offering higher margins and smoother cash flows for the company while providing transparency and reassurance for airlines in terms of cost predictability and engine salvage value.

Airlines prefer to engage in full-service contracts based on flight hours with OEMs because such agreements protect the residual value of the engine, ensure compliance across different regulatory jurisdictions, and minimize the risk of engine failure. By signing contracts with established OEMs that have a proven track record, airlines can be confident that their agreements will be honored. These factors contribute to further strengthen switching costs within Rolls-Royce's civil aerospace segment.

Furthermore, the company has made significant improvements in time on wing with around 40% improvement across its new-generation Trent engines, such as the Trent XWB-84. By using long-term service contracts, Rolls-Royce is able to convert these quality improvements into increased aftermarket profitability. 

Long term, the market dominance of narrow-bodies puts Rolls-Royce in a weak competitive position and prevents us from awarding a wide moat. 

The market for next-generation narrow-body engines is expected to be dominated by a duopoly, with Pratt & Whitney and CFM International as the major players. This makes it challenging for Rolls-Royce to reenter and compete effectively in this market.

Timing is also a factor. Boeing and Airbus, the leading aircraft manufacturers, have recently refreshed their narrow-body aircraft portfolios with the Boeing 737 MAX and Airbus A320neo, respectively. This means there are currently no immediate opportunities for Rolls-Royce to reenter the narrow-body market as it is unlikely that entirely new aircraft for this market will enter service until the mid-2030s.

Short term, supply chain challenges and cost inflation put a further downward pressure on company profitability. 

In response to these market conditions, Rolls-Royce undertook a restructuring initiative to align its capacity with the suppressed short- to medium-term demand environment. The company delivered GBP 1.3 billion in annualized costs savings through measures such as job cuts and production site consolidation. This restructuring effort included shedding of 9,000 jobs, which represents about 30% of the civil aerospace segment's workforce. 

The company decreased R&D spending to around 5% of revenue versus 10% in 2021, while also shifting the investment priority mix, by decreasing the proportion allocated to the current civil portfolio from 64% in 2019 to a midterm target of about 30%, and increasing the proportion allocated to next-gen engines to 50% from 32% in 2019, with the remaining 20% allocated to low-carbon technologies versus 4% in 2019. We believe that the around 5% new target and the investment mix are aligned to the wide-body lower market conditions and to competitors’ investments. Rolls-Royce competitors, Pratt & Whitney, GE, and Safran, enjoy a high exposure to the growing narrow-body market and invest between 4%-7% of their revenue in R&D. 

Looking at past performance, the company ROIC has been lower than the cost of capital even before the negative impact from covid, due to a combination of factors: including investing heavily in building market share by developing seven new engines and ramping up industrial capacity; large investments in R&D (in the order of 10% of revenue) without a clear path from management on how to recover the investments given the shrinking market share of wide-body aircraft; operational inefficiencies which forced the company to slow down the ramp up; and lower prices; and finally drawbacks in slower ramp up due to airframes platforms disappointing slow sales (for example, Trent 900 engine used on the dual sourest A platform which Airbus stopped producing very early on in its life cycle). 

Thanks to these investments, though, the company experienced significant growth in its installed base, which doubled when considering both large engines and the business aviation market. However, most of the new engines were about to reach break-even point when covid halted the market. Now the company has shifted its focus toward improving operational efficiency and capitalizing on its past investments while most of its engines are positioned to take advantage of the pickup in aftermarket revenues driven by the recovery in engine flight hours. We believe that the long-overdue restructuring was necessary and sufficient to support economic profit generation until ramp up of the new generation engines shop visits, underpinning a narrow moat rating.

Defense

The defense business of Rolls-Royce shares similarities with its civil aerospace original equipment business, particularly in terms of the need for extensive engineering expertise and technical know-how. The certification process for defense products is complex and demanding, creating barriers to entry and limiting competition. Therefore, we assign a narrow moat to the defense business based on intangible assets derived from Rolls-Royce technical knowledge. 

Program wins in the defense sector are typically long term, creating high barriers to entry and fostering intense competition among established players for new opportunities.

Within the defense business, services contribute to 54% of total revenue. Unlike the commercial aerospace sector, the defense sector faces challenges in centralizing maintenance due to the greater geographical dispersion of customer assets. Consequently, attachment rates of long-term service contracts are relatively low, at around 30%. As a result, the majority of 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 defense segment does not benefit from significant switching costs due to the low attachment rates. 

Power System

In contrast, the power segment of Rolls-Royce does not possess a moat source that can maintain economic profits over extended periods. The power segment operates in a competitive environment with intense pricing competition and short product cycles. These factors result in continuous product obsolescence and deflation, making it challenging for incumbents to establish a durable competitive advantage or moat in this segment.

Narrow

Economic Moat

Rolls-Royce Holdings PLC

Rolls-Royce Holdings Plc designs, develops, manufactures, and services integrated power systems for use in the air, on land, and at sea. The company operates its business through following segments: Civil Aerospace, Power Systems, Defense and ITP Aero. The Civil Aerospace segment offers commercial aero engines and aftermarket services. The Power Systems segment includes engines, power systems and nuclear systems for civil power generation. The Defense segment consists of military aero engines, naval engines, submarines and aftermarket services. The ITP Aero segment provides aeronautical engines and gas turbines. The company was founded in March 1906 and is headquartered in London, the United Kingdom.

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