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.