Shares in focus: A smooth ride to profits for Rolls-Royce?

Rolls-Royce shares are flying high, but is the income worth paying for? Phil Oakley investigates.

Ask people what best symbolises Rolls-Royce and they’ll probably talk about the big luxury cars with the famous Spirit of Ecstasy ornament on the bonnet. Yet the car business is now owned by German giant BMW and, in any case, cars were never its bread and butter.

Rolls-Royce was set up by Charles Rolls and Henry Royce in 1906. The backbone of the company has always been aircraft engines. Its Merlin engines acquired legendary status due to being fitted to Hurricane and Spitfire aircraft during World War II.

After the war, the firm’s success was based on its development of the gas turbine engines that went into the growing number of passenger aircraft.

Like most long-lived companies, Rolls-Royce has had its ups and downs over the years. In 1971, it was on the verge of bankruptcy after one of its engine projects suffered from major technical problems. It was rescued by the government, who nationalised it.

Since returning to private ownership in 1987, the company has branched out into new business areas – such as engine turbines for ships, power stations and oil rigs – while still remaining a world leader in aircraft engines.

The last decade has seen profits increase fivefold. But the share price has risen by even more than that.

So you could be forgiven for worrying that a lot of the expected growth in future profits has been priced in. Is it time to bail out of the shares? Or are they set to go higher still?

How the business is doing

Rolls’s subsidiary businesses of making engines for defence aircraft, ships and power stations are not expected to make a huge difference to its overall profitability. The case for buying shares in the company hinges on the prospects for its civil aerospace business and the number of Trent engines that it can sell. Here, the outlook is very promising.

Air travel across the world has been growing for decades – a trend that most aviation experts expect to continue. Lots of growth is expected to come from the emerging markets of Asia where the growing middle class wants to travel further and more frequently. This flows through to a growing need for more aircraft and more engines.

Making money is often a struggle for airlines at the best of times. One of the biggest threats is the volatile oil price – high fuel prices can cripple them. So they are investing in more fuel-efficient aircraft, such as the Boeing 787 Dreamliner (B787) and Airbus 350 (A350), to replace their existing fleets.

Rolls-Royce looks set to do well from these two mega trends and is looking to double its output of wide-body aircraft engines over the next five years as Airbus and Boeing ramp up production. It is the sole engine supplier for the A350 and currently has more than 1,400 orders. Competition to supply engines for the B787 is more fierce, but Rolls-Royce is doing a good job of hanging on to just under half of this market.

But the key to Rolls-Royce’s long-term profits lies in selling spare parts and doing engine maintenance work (known as the aftermarket). This provides a high-quality, visible long-term income stream (around 25 years per engine) that investors are prepared to pay a lot for. The more engines installed and the more aftermarket work, the more valuable the firm.

It’s also a business competitors find hard to break in to. Not many airlines are willing to compromise safety by using cheap spare parts or economising on maintenance. That’s why around 75% of Rolls-Royce’s installed engines are on long-term service agreements.

However, Rolls-Royce is not yet making the most of these strong markets. It’s not making as much money from engines as rival General Electric, whose return on sales (profit margin) is around 18% compared with Rolls’s 11%. Rolls intends to close the gap by squeezing its cost base, particularly its suppliers, where it hopes that a bigger workload will translate into bigger discounts. If it is successful then profits will get another leg up.

The company also has to work harder at turning its profits into cash. Aircraft-engine suppliers have to have a lot of parts and materials in stock to work smoothly. But Rolls-Royce – by its own admission – has too many. This is eating up a lot of cash resources. By cutting down it reckons it can free up significant amounts of surplus cash, which may help boost dividends down the line.

Should you buy the shares?

Strong demand, higher-quality aftermarket profits, lower costs and more cash makes for a compelling investment case. The stock market seems to agree, and is pricing Rolls-Royce shares on a very punchy 17 times this year’s expected profits. Ordinarily I’d say that this kind of valuation is too rich.

However, Rolls-Royce is a top-quality business with no debt, and is already making good returns on its investments that could get a lot better from here. The ability to turn engine sales into a high-quality, long-term aftermarket income stream should be highly valued. So if Rolls-Royce can continue to do this, there is still scope for the shares to go higher.

No doubt there will be some bumps in the road ahead, but Rolls-Royce is still a decent long-term investment and worth paying up for.

Verdict: long-term buy

Rolls Royce: LSE: RR

Rolls Royce share price chartShare price: 1,246p
Market cap: £23.4bn
Net assets (June 2013): £5.1bn
Net cash (June 2013): £921m
P/e (prospective): 16.9 times
Yield (prospective): 1.9%
Dividend cover: 3.1 times
Interest cover: 28.5 times

Rolls Royce dividends per shareWhat the analysts say

Buy: 14
Hold: 6
Sell: 6
Target price: 1,340p

Directors’ shareholdings

J Rushton (CEO): 202,632
M Morris (CFO): 62,750
I Davis (chair): 6,749