We are lowering our fair value estimate for Rolls Royce (RR.) to £6.55 per share from £8.61 as we reduce our revenue and margins expectations. Weakness in Rolls-Royce's civil aerospace business and its marine division will put pressure on revenue growth and profitably for the second half of 2015 and 2016.
We believe the shares are undervalued; but we expect short-term volatility
Rolls-Royce continues to gain market share in installed thrust; as a result, the company should benefit from increased demand for aftermarket services. However, we have begun to see reduced utilisation by some specific operators of older wide-bodied engines. This management of short-term excess capacity, as the market takes delivery of newer, more fuel-efficient airplanes, will affect aftermarket revenue and profit in 2015/16. Nonetheless, we maintain the firm's narrow moat, as the issues are cyclical rather than structural in nature.
The 2015/16 softening in end markets does not affect our narrow moat rating, as we believe Rolls-Royce is well positioned in the structural growth market, with its civil aerospace segment. The market will strengthen, driven by increasing demand for travel in emerging markets and the need to replace older aircraft with new fuel-efficient models.
The value embedded in the installed base carries with it an annuity of aftermarket services that will generate revenue for decades to come. The high barriers to entry imposed by the technical knowledge required to design and manufacture a jet engine keep out many competitors.
We believe the shares are undervalued; however, we expect short-term share price volatility, as management will update investors on operational midterm guidance, shareholder payments policy and strategic review. At this stage, Rolls-Royce has not provided comprehensive guidance for 2016 or updated its medium-term guidance, as set out by previous management. In our view, as a result of continued weakness in the firm’s end markets, a change to Rolls-Royce's policy of payments to shareholders could be expected.
On November 24, CEO Warren East will host a presentation to outline the initial findings of the ongoing operating review of Rolls-Royce's businesses. In April, after the announcement of East as CEO, we already expressed our concerns about corporate strategy. Rolls-Royce's management strategically chose to allocate capital and highly skilled labour to develop next-generation wide-body airframe engines, at the expense of the narrow-body airframe arena. The firm currently has no narrow-body engine offering, and will not join the party until 2020 to 2030, when new narrow-body platforms are going to be developed. We believe this will limit sales growth, as the bulk of aircraft deliveries will continue to flow to the narrow-body frames.
Additionally, Rolls-Royce has attempted to leverage its aero-derivative engine technology into other areas, including marine applications, energy power generation, and power systems, which have structurally lower operating margins driven by limited aftermarket services revenue. Revenue contribution from the land and sea division will be muted in the short term. On top of continued price pressure resulting from current shipyard overcapacity, future volume growth will be limited in the marine market, given the weak order trends over the past three years.
.jpg)
