EUR 850.00 For Business Accounts Only

Morningstar | RYCEY Updated Forecasts and Estimates from 05 Jul 2019

After taking a fresh look at narrow-moat Rolls-Royce, we reduce our FVE to GBP 11, 6% below our previous estimate to account for higher uncertainty about firm’s earnings profile. We can't precisely forecast key margin drivers such as flight time and spare parts on a year-to-year basis. We believe that multiples, such as the popular P/E, have a short-term view and misrepresent  Rolls-Royce's earnings potential. The engine business has a long-term return profile: at program inception, engines are sold at a loss owing to a lack of volume and discounts to gain customers.  Rolls-Royce  has a razor-and-blade model--selling engines at a loss to service them later. Over time, returns and margins will improve. First, the engines reach the profitability break-even point. Second, the installed engines need to be overhauled over time, which carry high margins. The aftermarket is secured through long-term agreements, 90% of Trent fleet.

Rolls-Royce’s shares are trading at a 20% discount to our FVE. The market is too concerned that the technical and operational issues (Trent 1000, 900 durability issues and Trent 7000 production delays) will hit engine sales. The missed opportunity to power Boeing’s new midsize aircraft, and thus re-enter the narrow-body segment, has also worried investors who are skeptical about the firm’s margins recovery. We do not see these issues as the main drivers of Rolls-Royce ’s margins. The market underestimates Trent XWB's key role in the group’s margins recovery and the aftermarket services potential. As a sole-source engine for A350 aircraft, the XWB represents 60% of the firm’s order book. Its successful ramp-up will boost the Trent XWB's transition from an operating margins drag to a positive margins contributor by 2020. We estimate Rolls-Royce total installed base will grow 6% over the next five years, regardless of narrow-body dynamics. This is very important for Rolls-Royce: a larger fleet drives the firm’s aftermarket with its high margins.