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Industrials

Rolls-Royce RYCEY ($6.85) Phoenix Rising From The Ashes

Turnarounds rarely succeed. Ask Warren Buffet, who tried his best to turn around textiles major Berkshire Hathaway, which was suffering from a barrage of cheaper imports (sound familiar?) before giving up and turning it into the holding company and investment giant that is today. Rolls-Royce (RYCEY) is in the midst of one in the cutthroat world of aerospace engineering and manufacturing and is having a banner year with its stock up 82% to date.

Can it continue or sink under its three difficult cyclical segments, aerospace, defense, and power with low margins and tough competition? –

A year and a half ago, CEO Tufan Erginbilgic took over a struggling company with pandemic-induced challenges, operational inefficiencies, and persistent financial setbacks. His approach was bold and uncompromising: radical cost-cutting, operational streamlining, and a laser-focused strategy to transform Rolls-Royce’s fundamental business model. He did admirably, trimming the workforce by 6% and reducing expenses by £400 million. He also raised prices, optimized procurement processes, and renegotiated contracts.

As a result, in the first 6 months of 2024, Rolls-Royce did an excellent job with

  • 19% revenue growth to £8.18Bn
  • 74% increase in operating profit to £1.2Bn, with an OPM of 14%
  • Free cash flow improvement by 225% to £1.2Bn
  • Net debt reduced to its lowest level in five years to £822 million

The turnaround was led by Civil Aerospace (its largest division), and the strongest performer with 27% revenue growth, which benefited from post-pandemic air travel recovery. What’s more, its higher-margin service revenues also grew 27% to 68% of division sales, indicating a robust and recurring revenue stream. The aerospace segment benefited from strong growth in in-flight hours for engines under long-term service agreements, and large engine deliveries to OEMs increased by 4% with overall OEM deliveries up 26%.

Besides the volume growth, Rolls-Royce also passed on elevated costs, after successfully renegotiating long-term service agreements. Airbus, which saw increased demand for the Trent engines and General Dynamics for its Gulfstream engines, as big customers helped; Competitor General Electric saw its equipment sales fall year-on-year in the second quarter due to lower LEAP engine deliveries.

Defense and Power Systems also showed growth. Defense revenues grew 18%, with strong submarine platform sales and higher service revenue. Power Systems saw a smaller 6% revenue increase, mainly from Datacenters, a segment that certainly holds greater promise.

What does the future look like and can they continue with the turnaround?

Aerospace: Rolls-Royce exclusively provides the engines for the Airbus A350 and A330neo and those airplanes have seen some solid sales momentum which will drive value for the company. The services division will provide better margins

Defense: Given the stronger Republican emphasis on defense, I believe Rolls Royce should see better impetus from defense budgets in the next 4 years.

Power: Data center power needs should be a great opportunity for Rolls-Royce especially with the small modular reactor. The UK government has already picked Rolls-Royce as one of four sources, as has the Czech electricity company, CEZ.

Key Risks:

Execution challenges: This is not their first trip out of the despair well, and once the benefits from cost-cutting dissipate, they still have to grow.

Exposure to global air travel trends, which will slow down after the post-COVID revenge travel boom. Regional revenues were lower and didn’t participate in the post-COVID travel boom.

The company is worth buying: I plan to buy Rolls Royce on declines after such a large run-up for the following reasons.

Reasonable valuation for a GARP (Growth At A Reasonable Price): Analyst consensus estimates call for revenue growth of 8-10% for the next three years at a paltry P/S valuation of just 2.4x sales. Rolls-Royce is also slated to grow EPS by 20% in the next three and has a reasonable P/E of 26, or just 1.3.

Improving margins: Given the improvements in operating margins and the focus on efficiency, margins could improve further and help earnings grow.

Diversification: The company’s diversified portfolio – civil aerospace, defense, and power systems – helps hedge against sector-specific cyclicality.

Datacenter Opportunity: I also believe that Datacenter requirements for power will be a big winner for Rolls-Royce.

Dividends: They’re also reinstating dividends at 30% of after-tax profits, which should provide a floor for the stock price.

Categories
Industrials Stocks

Caterpillar: A Well-diversified Market Leader 

Industrial cyclical – Caterpillar (CAT), Value stock Hold, can buy on declines. 

Has been a good value stock, returning 17% in the past year and 180% in the past 5 and 219% in the past 10, which is good for a cyclical barely growing revenues at 3% a year on average with peaks and troughs. Revenue and earnings estimates are also for low single digits for the next 3-4 years. 

Positives 

Increasing Service revenue stream will improve profit margins. They want to acquire more service companies and focus on this. 

They did manage to increase prices this year, not an easy task unless your product is superior in this industry – good brand recognition. 

Well diversified – lot of end user markets and customers from construction to O&G, and transportation. 

They will also get more revenue from AI – data center buildouts. 

Negatives 

  • Economic Headwinds: Global challenges like Europe’s manufacturing recession and China’s weak housing market could impact CAT’s performance, plus the US’ chances of a recession have now increased above 30% following a softer jobs market. 
  • Cyclical Nature: Despite diversification, its core industries are still cyclical, exposing CAT to economic downturns. 
  • Valuation Risks: The current stock price reflects much of its potential, potentially limiting the upside if we do not get a rebound in cyclical growth. 
Categories
Industrials Stocks

Deere – An Interesting Value Stock 

Deere and Co (DE) $345 Industrial cyclical, Value Stock. Hold for now. 

Deere underperformed CAT this year losing 20% but was OK in the last 5 and 10 with 135% and 308% share price growth. 

  • Deere’s focus is specializing in heavy equipment for agriculture, construction, and forestry sectors. 
  • This year is bad – Recent weak guidance and sales declines because of crop prices. The next two years’ forecast is also negative for both earnings and revenues 
  • But overall, in the last 10 years, Deere’s revenue growth has been far superior at 6% earnings in double digits as compared to CAT 
  • With a focus on cost reduction and expense management, Deere will improve but I suspect it could take at least year for some tangible results and its share price and valuation is not that low, we may see a bottom about 10-20% lower. 
Categories
Industrials Stocks

Robin Hood: Too Expensive To Buy Now. 

Robin Hood (HOOD) $17.73 HOLD – Its trading at a premium to its peers, will take another look if the price drops significantly.  

Positives 

Has a decent strong hold with retail trading community, a preferred broker to those who started trading during the pandemic – First Mover advantage. 

Wide offerings in crypto trading and services – crypto is the largest revenue stream. 

Negatives 

Cyclical, commodity, not much difference between brokerages, at one time commission rates used to be a differentiator, then it was ease of online trading, which was a small differentiator for Robin Hood when it took of during the pandemic, now everyone catering to retail seems to be on par. 

  • Interest rates from the customers float drive a big chunk of revenue, and a large recessionary rate cut would likely erase most of that revenue segment. 

Too much exposure to crypto volumes tank when crypto is down 

Valuation 

The stock is trading at a premium to its peers like Interactive Broking IBKR, which doesn’t seem justified. 

Categories
Industrials Stocks

Lumen Tech Could Be A Turnaround Stock. 

Lumen Tech (LUMN) $5.50 Cyclical, 

Stock has appreciated a lot this year, 220%, but 5- year and 10-year stock returns were negative, because as a Fiber Network Telco – it was a cyclical, commodity, capital intensive, high debt, low margin business. Sales have declined in the last 10 years by 21%. 

What is different now – Corning and Microsoft has helped it stave off bankruptcy, its debt load was too high for it to sustain its business, otherwise. 

  • Lumen’s partnership with Corning for fiber network expansion will support business growth and increased free cash flow forecast for 2024; this may lead to debt rating upgrade and improved growth. Markets responded enthusiastically to the news, since Lumen significantly increased its capacity to key cloud data centers. AI has heavy workloads and uses high bandwidth applications since it involves massive amounts of data. 
  • They have a similar customer supply deal with Microsoft. 

I tend to avoid commodity cyclicals because they don’t have sustainable, recurring growth, you have to constantly watch over your shoulder, and in Telecom and Networks capital requirements are usually very high. Plus, in Lumen’s case the stock has jumped for a bottom of $1, so much of the good news is in the price. If you decide to buy on a dip, you may get a solid bump for a year or two, but not a long-term great company. High Risk/High Reward for a year. If they continue to get more deals and AI network expansion continues yes this could be a good deal, but this industry is intensely competitive and price sensitive. 

Categories
AI Industrials Stocks

Microsoft Disappoints Markets 

Microsoft (MSFT) shares fell nearly 7% in extended hours trading on Tuesday after the tech giant reported fiscal fourth-quarter results that topped expectations, but Azure growth was weaker-than-expected or simply the expectations were too high. 

For the period ending June 30, Microsoft earned $2.95 per share – above $2.93 guidance as revenue rose 15% year-over-year to come in at $64.7B – above 64.52 guidance 

Included in that was $28.52B from its Intelligent Cloud division, which consists of its Azure cloud unit. Microsoft said Azure revenue grew 29% year-over-year and 30% in constant currency. 

The company previously said it expected Azure to grow between 30% and 31% in constant currency, and some analysts previously said they expected more than 30% growth. 

Guidance for the Sep quarter will come in with the call. 

Categories
Industrials

In-Depth Analysis of Archer Aviation (ACHR): A Speculative Play in eVTOL with R&D Challenges and Competitive Landscape

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Archer Aviation (ACHR)

Pre-Revenue, majority spend in R&D.

Lot of dilution (likely to continue at double digits each year if not more) due to equity funding for R&D, still has about $325 Mn in net cash a year worth of expenses.

Positives include a $140Mn DoD contract, plus scope to expand in India and the middle east. United Airlines even though it is a large strategic partnership, it is non-binding – so difficult to predict what might transpire.

Also, an ongoing effort to reduce expenses to stretch cash a couple of years.

Biggest negative/challenge is getting certification and there is a milestone for 2024 testing so let’s see how that goes.

Interestingly, if eVTOL (Vertical take-off of aircraft) gets a mandate it would be a massive market.

Closest competitor among many is Joby is at a similar position developmentally and operationally, their ongoing testing program has a likely 6 to 12-month lead over Archer Aviation with successful flights in NYC, but Archer should be able to close that.

JOBY’s key supplier relationship with Toyota is a big plus.

ACHR’s primary focus is on manufacturing and selling eVTOL aircraft, while JOBY’s business model is more full stack, creation and operational management, thus Joby’s valuation is stronger. 

Bottom line – speculative volatile play for sure + definite dilution, but if successful could be huge. I’m sure your position would be small relative to the portfolio, and as long as you can deal with the volatility nothing wrong in accumulating but do keep an eye out on JOBY, the Toyota angle looks interesting.

Categories
Industrials

Investing in Vestis Corp (VSTS): A GARP Opportunity in Uniform and Workplace Supplies

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Vestis Corp (VSTS) Buy $20

3-5 Years, Target $40 to $45. Annual Gain – 18 to 20%

GARP (Growth at A Reasonable Price)

Vestis (NYSE: VSTS) is a uniform and workplace supplies provider that’s just been carved out of Aramark (ARMK). A competitor to the very successful Cintas (CTAS), now just likely to start hitting the gas. Cintas, priced around $50 on December 13th, 2013, closed at $600 at year-end, 2023 – a twelve-bagger in 10 years! That’s an annual growth of more than 28%! I believe Vestis can emulate Cintas’ story.

These are the main reasons to buy Vestis:

1. Sustainable long-term revenues and income from long-term contracts with 93% of clients renewing each year.

2. Scale – It is the second largest provider in the rental uniforms and industrial supplies market after the $6.9Bn Cintas. Scale matters, making it a barrier to entry for smaller players unable to serve multiple locations. Operational efficiency is the reason for Cintas’ dominance – smaller players can’t do it at the same price as Cintas and Vestis, and it is far more expensive for industrial customers, local government authorities, franchises, hospitals, and restaurants to do it by themselves.

3. Fragmented market – the opportunity is tremendous, the big three players control only 25%, and it being the second largest player there is plenty of room to increase market share.

4. Cross Selling – increasing revenue per customer. Management believes that only 30-40% of Vestis’ product line is being sold and there is ample room for improvement, especially for workspace supplies.

5. Leverage Delivery agents to increase sales – continue leveraging the front line by making salespeople of its delivery agents. Currently, Vestis’ delivery agents sell on 96% of routes. These are valuable assets and will be leveraged more.

Even if Vestis emulates most of Cintas’ story we have a solid winner on our hands.