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Morningstar | Charge Overshadows Stellar Improvement in Rolls-Royce's Civil Aviation in 3Q; Shares Undervalued

Narrow-moat Rolls-Royce reported excellent first-half revenue of GBP 7 billion, up 12% year over year on a reported basis and up 14% on an organic basis, with underlying operating profit increasing to GBP 141 million, improving on an operating loss of GBP 84 million last year. Unfortunately, solid operational progress was overshadowed by a one-off charge of GBP 554 million for additional inspection, certification, and intervention costs for the Boeing 787 engine (Trent 1000). With certification testing of a redesigned compressor rotor blade for Trent 1000 Package C engines in progress, followed by a redesign for Trent 1000 Package B engines, we believe long-term solutions are in place, resulting in significantly lower expected cash costs for the Trent 1000 engine issues after 2020. We retain our fair value estimate of GBX 1,140 per share for the London-listed shares, and $15 for the ADRs, along with our narrow moat rating.

We still view Rolls-Royce as one of the most attractive investment opportunities in our coverage, and our differentiated stance is based on bullish expectations for the firm’s civil aerospace profits resulting from dominant positions, especially on Airbus' fast growing widebody aircraft platforms. The 24% year-over-year growth rate in wide-body aerospace deliveries for first-half 2018 supports our thesis.

Strong growth and rising profitability in the first six months of the year for the civil aerospace segment (revenue up 19% year on year, with margins expanding by 560 basis points) and the power systems segment (sales up 15%, with 340 basis points of margin improvement) were the main positive highlights. Strong volume growth for the Trent XWB engine, which supports the wide-body Airbus A350 aircraft, boosted civil aerospace revenue in the period. Margins strengthened due to strong demand for this high-margin service revenue, driven by both increased engine flying hours (mainly applicable for newer engines) and higher time and material activity for older engines. Invoiced flying hours from in-production Trent engines increased 20% in first-half 2018. Power systems revenue was supported by improved commodity end markets and government project wins and profitability increased due to operational leverage, better factory utilization, and cost savings.

Rolls-Royce's cash return on invested capital should increase as losses on engine equipment sales diminish and high-margin afterservice increases within the revenue mix. In the first six months of 2018, Rolls delivered 259 wide-body engines with an average negative cash margin of GBP 1.36 million per engine. We believe this cash deficit per engine should improve over the next five years to negative GBP 0.4 million per engine as production of Airbus A350 and Airbus A330neo ramps up, the learning curve effects kick in, and Rolls moves through launch customer pricing.