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Rolls-Royce Holding PLC: Mind The Gap

In the past month, we have built a new core position in Rolls-Royce. We have been uncharacteristically quiet as it relates to our latest core large-cap position, because we’ve been trying to influence the focus of the new CEO (who has an excellent track record) on operational issues. We’ve also been trying to build a groundswell of support for our operational plan amongst some large suggestivist investors – although not ValueAct oddly enough, as Ubben is one of our role models. Now that the horse is leaving the barn on the Rolls-Royce opportunity, and an earlier copy of our research has been posted elsewhere, we’re pleased to publicly post the research that we shared with investors earlier in the month.

Rolls-Royce is going through a perfect storm right now. It is rapidly growing its large engine installed base (it has the most fuel efficient large engines in the world), and it’s selling these engines at a loss. While Jeff Bezos would love this long-term investment prospect, nearly everyone else in the western world has run away. Only 18% of sell-side analysts still recommend buying shares of the company, and confusion is running very high – consensus operating income estimates for next year are for anywhere from £1 billion to £2 billion. You could fly an A350 through that spread, it’s so wide. Actually, if we stacked up the coins of one billion quid, the distance would be able to accommodate over 45,000 A350s simultaneously.

In our first research piece (with assuredly, many more to come), we have sought to engage in a discussion about the one factor that will make the biggest difference in our investment returns in Rolls-Royce: the deep margin gap its civil aerospace division has relative to GE. While a cyclical recovery in capital spending in the land & sea division (we’re not counting on it), could drive a fair amount of incremental upside (perhaps £1.00-2.00), it pales in comparison to the significant opportunity the company has if it were to emulate its American competitor and fix the margins on its engine sales. The financial metrics presented herein are a bullish scenario if the company were to enact the operational initiatives described. Until the company starts taking action, they will most certainly be wrong, and be too optimistic. Furthermore, we have continued to refine our model assumptions since this report was published, and will be publishing...