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- Rolls Royce - Going Bust or Going Nuclear?
Rolls Royce - Going Bust or Going Nuclear?
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Rolls Royce.
The name has been associated with pioneering & innovation for over a century.
But their share price has been absolutely decimated by Covid-19...
It has plummeted this year to levels not seen since 2004.
('Plummet' is a word that's thrown around far too casually but in this case, it is genuinely appropriate).
Just look at that chart. 🤢
RR started the year just below £7 per share, and was as high as £11 in mid-2018.
So, what went wrong?
This year has been all about the virus and lack of air travel.
Since the 1980's RR has used a ”power-by-the-hour” model for its aircraft engines.
Essentially, the customer is billed for every hour of performance of the engine, while Rolls-Royce retain ownership and maintenance obligations.
A great idea, until those engines are no longer in the sky.
In February 2017 Rolls-Royce posted its largest ever pre-tax loss of £4.6 billion; This included a £4.4 billion writedown on financial hedges that the company uses to protect itself against currency fluctuations, and a £671 million penalty to settle bribery and corruption charges with the Serious Fraud Office (SFO), the US Department of Justice, and Brazilian authorities.
On 14 June 2018 the company announced a restructuring of the business to create three simpler decentralised units (civil aerospace, defence and power systems), to rationalise back office functions and to remove middle management functions. The cost savings should amount to £400 million per year by 2020, with an up-front restructuring cost of £500 million. Some 4,600 people are likely to leave the business out of 55,000 employed worldwide, 3,000 job losses from the UK and the rest from elsewhere in the world (15,700 of the employees work in Derby and 10,300 work elsewhere in the United Kingdom).
In August 2018 Rolls-Royce announced it was taking a charge of £554 million to cover faults with some Trent 1000 engines on Boeing 787 Dreamliners; Rather than going thousands of hours between inspections, the faults with turbine blades mean the engines currently require inspection every 300 hours of flight. In the same announcement Rolls-Royce said it would spend £450m fixing faults on the Trent 1000 in 2018, £450m in 2019 and £350m in 2020, with the work complete by 2022.
In May 2020, the company announced that they will be cutting one fifth of their jobs (around 9,000) worldwide as a result of the COVID-19 pandemic.
Around 3,000 job losses were expected in the UK, half of them in Derby.
To top things off, Reuters reported (1st October 2020) that;
Rolls-Royce plans to raise a total of 5 billion pounds, including 2 billion from shareholders, to cope with a “worst case scenario” as the coronavirus travel crisis crushes the British engine maker’s cashflow.
The FT offer some more detail;
In addition to the rights issue, in which new shares will be priced at 32p each, Rolls-Royce announced plans for a bond issue of at least £1bn, a new two-year term loan facility of £1bn, and agreement in principle from the UK Export Finance agency to guarantee a further £1bn loan on top of £2bn granted in July.
The rights issue must be approved by shareholders later this month. (likely to be on the 27th of October)
About £3.2bn of the company’s existing debt falls due next year, which has put it under pressure to refinance.
Warren East, chief executive, said the measures represented a “comprehensive package which will take the liquidity question off the table during this crisis. This is a final step to fixing the damage done to the balance sheet.”
The funding plans (BBG):
A 10-for-three rights issue, which will come at a 41.4% discount to Wednesday’s closing price, has been fully underwritten
A 1 billion-pound bond offering will proceed in the near future
Contingent on completion of the equity offer, Rolls said it also has commitments for a two-year term loan of 1 billion pounds
U.K. Export Finance has indicated backing for an extension of its 80% guarantee to support a 1 billion-pound increase in an existing loan, subject to completion of the rights offer
Moody's and S&P have both downgraded the company to junk status in recent months.
Fitch also downgraded Rolls-Royce to 'BB+'; Outlook Negative.
Yep, this stock is cheap for a reason (lots of reasons, but I digress).
Let's take a closer look at the overall business.
Civil aerospace is clearly the largest driver of revenues, at just over 50% of the total.
Other revenue streams include the design and manufacture of engines and turbines for the defence, marine, and oil and gas industries.
(Note that ITP Aero may be sold this year).
Many experts predict that long haul flying will not return to previous levels for another 3 to 4 years.
Most RR engines are used in widebody aircraft, so if that is the case, then it certainly presents headwinds.
Although, if that is already expected, perhaps there is limited scope for the share price to continue falling from here?
The recent restructuring has reduced costs, and the refinancing will provide healthy capital buffers.
Realistically how much worse can it get?
Buy while there's blood on the streets?
Well, perhaps there is a relative floor under the price for now.
However, none of the above makes a particularly compelling case for owning RR stock.
Sure, they might do fine, and perhaps things won't be as bad as everyone thinks for the aerospace sector after all.
But, that's not really a good enough reason to tie up capital in their stock.
It could sit there a few years and earn minimal returns.
Remember, they are cheap for a reason and a perfect example of why value will under-perform growth.
Although... (that word again)
What if they somehow became a growth company?
In a low interest rate world, lots of companies operating with heavy losses are highly valued because of their potential to 'change the world'.
They are valued on their future potential rather than the present.
Yet many of these companies don't even generate revenues, and their expertise is somewhat... unproven.
Say no more...
Rolls Royce have been at the forefront of aviation innovation for decades.
But what about the rest of the group?
They also have strong defence connections, and are applying their know-how in power systems too.
In their own words,
Rolls-Royce has customers in more than 150 countries, comprising more than 400 airlines and leasing customers, 160 armed forces, 70 navies, and more than 5,000 power and nuclear customers.
Let's get to the point.
Society is only just beginning the monumental transition towards cleaner energy.
Here is a company with a track record spanning decades, specialising in industrial technology and power systems.
Their expertise is practically unrivalled, and they even have a proven, well-established Maintenance, Repair, & Overhaul (MRO) service.
Surely this will attract orders from large firms and governments.
Competition is relatively sparse in this space too.
"Rolls-Royce was the only manufacturer worldwide able to utilize its long-standing experience in this specialized field and develop gas protection for straightforward gas engines, all in line with our schedule requirements and backed up by the relevant feasibility study," pointed out Carsten S. Wibel, head of Abeking & Rasmussen Special Vessels GmbH.
Those comments are taken from this press release;
That gas engines are being used in this project is owing to a German government directive that requires a massive reduction in CO2 emissions from governmental vessels.
How many governments have similar directives?
Net-zero by 2050 is an ambitious target.
In June, This Is Money reported that
A consortium of British businesses led by manufacturing giant Rolls-Royce has submitted proposals to Ministers to accelerate the building of a new fleet of mini nuclear reactors in the North of England.
The plans, circulated in Whitehall 'in the last few weeks', could see construction of high-tech factories to build the small reactors begin by next year.
There are high hopes for these small modular reactors.
It has been estimated that exporting small nuclear reactor technology could be worth £250billion to the UK if the programme is successful.
Sixteen Rolls-Royce-backed reactors, each able to power a city the size of Leeds, could be built by 2050. The project would employ 40,000 people.
Hundreds of related jobs would be created this year if the Government gives the green light.
The plan to deliver British-made nuclear reactors would help the Government to meet the UK's commitment to shift to clean energy by 2050.
It would also appeal to Tory MPs keen to reduce Britain's reliance on China. Chinese firms are currently appointed to build large nuclear reactors in Britain at locations including Sizewell in Suffolk and Bradwell in Essex.
However, there are growing concerns among senior Tories about Chinese influence over critical infrastructure in the UK. Prime Minister Boris Johnson has indicated his intention to distance the UK from China economically, amid talk of phasing out Huawei's involvement in Britain's new 5G mobile internet network.
Should the UK government wish to stoke some post-Brexit nostalgic nationalism, announcing projects with an iconic British brand would certainly be a savvy PR move.
With the end of the Brexit transition period, and the likely conclusion of the UK’s access to the European Investment Bank, the government should create an infrastructure bank, which could form part of a larger investment institution to support the UK’s economic recovery.
The UK treasury was already drawing up plans back in July.
Rolls has positioned themselves well to play an important role in the coming energy transition, plus their British heritage may see them favoured by a government keen to promote their Build Back Better agenda.
(Build Back British?)
Rolls are developing diversified systems, including battery storage, gas systems integrated into solar farms, microgrids, sustainable fuels, electric aeroplanes, hybrid rail powerpacks, and the small nuclear reactors too.
The government holds a "golden share" in Rolls-Royce which prevents the company - which is deemed to be of strategic interest to the UK - from coming under foreign control.
Perhaps not too BIG to fail, but probably too important to fail (which should limit the downside potential - nationalising seems unlikely).
The general thesis is that the company is well-positioned to provide energy systems and solutions, which should comfortably see it through the next few years, even allowing for reduced flying hours in the aerospace sector.
As the aerospace sector recovers in the coming years, the share price would be expected to mean-revert.
There is also an argument to be made that long haul flying will take some travel market share from the cruise industry.
After all, what kind of lunatic comes out of lockdown/restrictions and decides to go on holiday in a floating prison?
The final piece of the jigsaw is the UK government.
FT, 5th October 2020
FT Opinion 5th October 2020
In the meantime, there is more the government could do to help stimulate demand.
Ministers could also offer research and development incentives towards the development of less polluting engines.
France has promised its industry support towards a green aircraft.
Rolls-Royce is developing a more efficient engine that will need funding.
An alternative revenue stream beckons in small modular nuclear reactors.
The government has said it will publish a new industrial strategy this autumn.
Ministers should beware of allowing Covid-19 to dictate long-term industrial policy.
But it is high time they started thinking about the future of British industry.
Government policy may also look to address 'regional inequality'.
If the nuclear sites are approved, or any other technological breakthrough is achieved, then we could see some serious upside and speculative flows.
The upside for RR compared to your average 'value' stock, is this disruptor growth potential and prospects for government favouritism.
Take a look at what they have been working on;
Summing up, there is potential for a strong asymmetric play here.
It's important to note that this is highly speculative.
Capital must be deployed, but there are also rules about allocations and risk diversification.
That said, if you manage money and have to balance your portfolio between 'growth' & 'value', why not prioritise value stocks with potential for growth...?
And if you are going to put money behind a disruptor/innovator, why not put it behind one who has actually innovated?
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