Rolls-Royce: Turbines and Tribulations - [Business Breakdowns, REPLAY]

28:09Of course, there's a service element there as well. I think that would be the spectrum. There's a trade -off from a margin perspective. You can operate with lower margin and offset that with higher volume, so gross profit is still growing. Is there any underlying data to suggest that there's market share gains, which are offsetting any of those lower profitability dynamics happening on the MRO side? There's always that dynamic of can you drive volume through market share? Yeah, there is always a trade off there. It's absolutely true, but I think when it comes to a market where you've got to do openly in wide body like you have today between Rose Royce and GE, there just is a level at which the market as a whole, I, all the customers want to see at least two thriving businesses in there with some level of price competition between them.

29:06Once you get to that type of market, I think it swings a little bit more towards optimizing your margin and optimizing for share. That is something that Rolls -Royce hasn't got right in the past. I was increasingly trying to do that going forward. The aerospace business is a fascinating ecosystem in terms of where the value capture happens. You have dual opales in certain spots and then you have the airlines which have historically not seen nearly as much value capture while a lot of the suppliers have at least found a way to balance and create those well -managed two -opolis. I'm curious on the customer front if Airbus or Boeing are releasing a new model aircraft.

29:49Are they selecting one engine provider? Do they ever mix and have a certain amount of the aircraft with a GE engine and the other percentage of the aircraft with Rolls Royce engines. The airframe makers are increasingly selecting for one provider, especially on wide body, where the volume is lower, I less scale. So the A350, for example, is exclusively using Rolls Royce XWB engine. The 330 Nio is exclusively on their trend 7 ,000. I think there are pros and cons of single sourcing. There's obvious ways that that falls over, but the big plus is scale, which lowers cost, plus you can optimize the aircraft holistically, and that's increasingly becoming more and more important.

30:38If you can work with an airframe early on on a specific new design and optimize both the engine and the F -RAM together for performance that can lead to very, very meaningful efficiency gains, just because the engine is such an important piece of the whole. If you've got two engines on it, then you're basically bolting on a slightly different engine onto an F -RAM and you can't run that holistic optimization as well. We've talked a little bit about the margin profile at a high level. Can you put some numbers on the business just in terms of whether it's buy segment or however you would lay it out, what the margins actually look like.

31:16They all sit in the high single digit for the very low end to, I would say mid -teen margins across all of their businesses. And I would argue that the efficiency of the whole of the whole choice is below it, should be. There's probably a few divisions in there that are reasonably efficient and operating at their margin capacity. you can take bits of power systems and compare them to something like a caterpillar or you could take Rolls Royce's Civil Aerospace Business and compare it to the GE Aviation which is now standalone. There are big margin differences between those. So in the Civil Aerospace which is probably the most important in terms of profit going forward and profit improvement going forward, it's sitting low -teen operating margins and they think and we think they can get to high -teen over the next five or six years through all of the things that they're doing to optimize on the revenue side, on the cost side.

32:11Where's GE out of curiosity? It's in the low 20s. Big difference. And when we originally invested in 2015, it was on that view that there's so much fat that could be cut in this business just because of that meaningful difference. Part of GE's margin is because they've got more scale through the narrow body business. They just produce more engines or be a smaller ones through the narrow body segment. but I don't think that accounts for anywhere near the difference with Rolls Royce today. We've alluded to the pricing of what they're doing. You mentioned cutting the fat. Is it excess labor costs?

32:48Obviously there's geographical dynamics in terms of where you upgrade and the cost associated with that. But is there anything else that stands out where this is a line item where it is just massively mismatched versus either competition or what you think should be reality. So when you management came in, this was a couple of years back. There've been a few management teams over the years. They had really tough period after GFC or not long after GFC, and that was where Trent 1000 started going wrong on the Boeing planes. And really the first meaningful engine blow -ups since the early 70s, always having little issues, but this was a meaningful problem they had with the blades wearing out too soon on the engines.

33:32There was a change of management then and they brought in the CEO or an East and he was already on the board of Rolls -Royce. He came in knowing that changes needed to be made and he was gradually making those changes, let's say from 2014, 15 on, then COVID hit that caused incredible disruption for this business. Most businesses, when they go through a downturn, they lose their earnings or earnings might go negative. They don't lose their revenue. Rolls -Royce lost their revenue because their revenue is based on flying hours and all the planes in the world more or less were grounded and so they lost their revenue stream and extraordinary period.

34:09That was a little bit of a double -edged sword for roles because on the one hand it was an absolute disaster and they needed to raise a whole bunch of capital to survive. On the other hand, turning around a business that is under performing to the degree it was under performing in terms of the margin profile is hard and War and East was found finding it very difficult because there are unions, because if you're going to a customer and saying, look, the margin profile on these long -term service agreements, it's just not sustainable for us. What does the customer do? They're not going to just say, okay, it's very difficult to come to different terms with customers.

34:48It's very difficult to change your cost structure in normal times. And what the crisis did is it gave Warren and the new CEO came in in 2022, two -fand, he came in from BP as more of a turnaround expert. Warren did a good job, was finding a difficulty to push the very tough changes through. Two -fand came into the business at a point where the platform was burning and therefore, if they didn't make the changes, the business wouldn't survive. So never waste a good crisis in other words. So what he's been doing is going through the cost structure line by line and that's not just people it's procurement and materials it is locations and consolidating some of those it's also on the revenue side having those tough negotiations with your customers to make sure that the insurance contracts are profitable taking out every opportunity to do that If it's increasing the time on wing, so if you can increase the time that the engine is on the wing of the plane, then that's positive in two ways.

35:55Number one is Grafier customers, the customers love that in the sense that they can fly more and you're getting more on the RTSA's because you're getting paid per flying hour. And you're extending the time to your next overhaul, which are very, very costly things, because you'll take the engine off the plane, bring it in, do the overhaul. So if you can extend that time on wing and you do that through the analysis of data and making sure that you're really tracking the performance of your engines in real time So you can pick up any problems early so they don't become a huge problem in the future My follow -up was question was going to be that I Assume you could only make that engine type to wing dynamic work by releasing or putting into production higher quality engines that are going to last longer.

36:38It does sound like there are things that you can do while an engine is actually in service to ensure that that's happening. Is that just a matter of, it's easier to fix a problem when it's small versus when it ultimately craps out? Yes. Now, if your engineering is poor to start with, there's not a lot you can do. Takes an awful lot because you have to do some fundamental redesigns within the engine while it's in use and that's an absolute nightmare and that's what happened with the Trent 1000. The story with the Trent 1000 is there was a bit of a change in spec for the engine and Rolls Royce. Again, wanting to design the best engine, being an engineering firm, wanting to keep the customer happy, they said, okay, we'll change the spec halfway through and that led to all sorts of issues and overruns and eventually a suboptimal engine.

37:22So now they're much more strict with luck. This is the best engine we have. This is how we're going to build it and you can't just go changing the spec halfway through that causes problems through the whole life of the engine. These things can go for a very long time. But it is both the XWB is performing very well, but they will have issues along the way with it. There's some evidence that in more dusty, hotter climates, it doesn't perform quite as well as they thought so. That means they can make some tweaks to those engines to help them perform a little bit better in those environments, etc.

37:50So you're always monitoring using the data and trying to pick things up early. Does the industry view Rolls Royce as having higher quality engines than GE. I think it depends on the program. Now I wouldn't say overall there's a view that one company is superior to the other, but they're always trying to push to have the next level of engine in terms of efficiency and quality. That's a bit of a double hedge sort. You can use the example of the wind energy industry. Any industry that makes these big machines is subject to this type of dynamic in the wind industry and that they make these big turbines, similar idea of massive bits of the kit and there's only a few players because these things are so expensive and so big.

38:34So if you think of a wind turbine, it's a massive blade that turns when the wind blows. The way the industry went was the company that could make the most efficient blade, the most efficient turbine, got all the orders. And we're still on this treadmill. There's this race. Every time a new turbine comes out, your back orders of your older turbines disappear. because everyone orders the new one because it's the most efficient. And it's the same for your competitors. So then you get this treadmill of trying to make the most efficient turbine and you're constantly putting in R &D, you're constantly putting in capital to get to the front end of that race so that you can get orders and win share and it's decimating your R &D you've put into previous models and it really hurts competition.

39:19So when you're on that treadmill, it's a very, very tough industry to be in and we've been in phases of that in the aerospace business, historically with engines. I think today it's much more stable because everyone recognizes this dynamic. Everyone wants to get to that next level of efficiency, but they're not working on it constantly and just bring out engines that are slightly better. They're waiting to the point where the technology is such they can bring out a meaningful, you better engine and then probably G and Rolls Royce are both work on something similar in concert. And then those will come out on the similar timeframe.

39:49then you can share that market, keep it competitive for customers and ultimately for consumers, but that's a much more healthy dynamic for the industry. What is that time frame between new models being released? You mentioned it seems like it's gotten longer, but any context there. I'm hoping it's gotten longer. You never know when the competitive juices kick in and the engineering juices kick in. There hasn't really been a point in the last 25, 30 years where they haven't been in development of a new engine. I would say this is the first period where they're not putting in a huge amount of R &D for the next generation.

40:26Some of the R &D went in five or six to seven years ago, pre the current management team went a little bit more on that treadmill. So there is a bank of R &D that's sitting there for the next generation, which probably comes out in the early 2030s, or at least they start in that production cycle in the early 2030s. So I think we're going to get get now 5 or 6 year period with a bit of a quiet time for R &D for the next program. It also you have to line it up with the air framers because the work on new engines will often sync with a new plane. If you look at the wide body market now, you've got the 350 from Airbus in the 787 from Boeing.

41:05They're both very good planes and they've got very reliable engines, customers love them. And Abus has no big desire to start working on the next generation that will come towards the back end of this decade, maybe early next decade. And then I think that's when you'll get some engine CapEx kicking up as well. Makes sense to have some synchronization between customer and supplier there. The CapEx and R &D intensity, can you frame that in terms of numbers, whether it's run rate or what you see in periods of time where it is elevated any context of that and generally tying it back to any free cash flow of the business in generate through cycles.

41:47In the many, many billions, the other reason you haven't seen many new entrances is it costs many, many billion to develop a new engine and if you want to do the whole R &D upfront to get to the point where you can actually build it, start the program up and you're in tens of billions plus for a high single digit margin business or low teens. Exactly. And then you'd have to break the market share. It's just pie in the sky for anyone who's thinking about getting into this industry. In terms of free cash flow, if you have a good engine program, the engineering is good. And you've priced your LTSAs in a way that's appropriate for the risks in any engine program going forward.

42:31and you've got your costs under control, then this can be quite a free cash flow of generative business. Because of the way the LTSA's work, you don't have to build lots of working capital as you grow because you're getting a lot of your revenue back up front. If you think about a single LTSA for a single engine, what happens is, as soon as that engine starts flying, you start getting some revenue in the door. And so you can think of that as negative working capital because you're not gonna spend on that engine until the overhaul comes in sort of 4 -5, it is significantly, you're spending a little bit over time.

43:04So you can grow without a build in working capital, which means you have free cash flow, conversions quite good. And if you price your contracts well, it can be a very, very free cash flow of generative business. But we haven't seen it. And I think there's still a lot of skepticism with Rolls Royce especially, because the history doesn't tell you that it's a free cash flow of generative business. The history tells you it's lumpy and things go wrong. and occasionally you have a crisis and they have to get bailed out. It is a bit of a game of trust with this business. On the top line side of the equation, sounds like it's fairly straightforward in terms of engine sales and then certain amount of miles flown, which I would imagine track to the industry fairly closely.

43:45But is there anything else you would add in there just in terms of top line growth and the cyclicality to it or any other major drivers. Very, very steady. So outside of pandemics. Yes. Besides that one big sudden stop, yes. That's right. The growth drivers are quite good. On the OECide, you could say, oh, it's quite lumpy, but I mean, they've got this big older books. So it's quite a predictable older book in terms of the original equipment sales. On the order book, you did mention with the wind turbines that back lock of orders can sometimes go away. I always find the order books to be so interesting across industries Some are much stronger in terms of the contractual nature than others, but how reliable is that?

44:28There has been some lumps historically. I would say going forward I would expect them to be very robust. There's a few underlying Secular dynamics behind that one is the number of people that fly every year tends to go up and a rate that's faster than GDP growth. The reason for that of course is that But most of the people in the world don't have passports less than 10 % of the people in China have a passport in India the same two massive populace nations. More and more people are entering that flying market. So you're getting a GDP plus growth rate in the industry as a base. But the most interesting thing I think in terms of today is that if you go from 2019 to today, the number of people flying is up as you'd expected to be up given population growth and wealth growth over that five year period.

45:18So a lot of growth in the demand for flying. But what's happened in that COVID period is there was a massive under supply because of all the supply chain disruptions and its disruption in production is a massive under supply. There's a hole in the supply of metal or planes into the industry. What that leaves you with is a very skewed supply demand environment today. There's a massive demand for new planes to come into because You've got all the planes rolling off the back end and you've got this hole in the period where they weren't produced. And what I think that leads to, you know, if you think of that structural GDP plus, you're gonna get GDP plus plus because under supply can't come all at once.

46:00You can't just fill that hole all at once. It's gradual and she have this nice gradual tailwind over the next sort of five, six, seven years on the original equipment side. So that backlog, I think, is very secure. And then on their long -term service agreement side, it's just flying hours. So if people are flying a bit more, they're flying really less. That doesn't really move up and down that much. If you have a big recession, it will move down a little bit and then recovers. But that's that GDP plus trend. Does Boeing's challenges have any impact on Rolls -Royce? Not really, because the challenges have been in the narrow -body segment.

46:37their wide -body segment, which is really critical for Rolls Royce in terms of its backlog effectively, Boeing have a pretty reliable play in the people like. Even if it had happened though to Boeing today in the wide -body segment, it might have an impact on Rolls Royce going forward, way into the future in terms of winning more business today, but the bulk of their free cash for today is on those existing stock of engines flying around the world. You've touched on it a few times, but this nuclear reactor business, which is this potential opportunity for them, is there any way to frame that actual size in terms of relative to the business or how big you think it could be just a time frame for that playing out?

47:22It's not something the role has really talked about in any kind of promotional way because they don't make any money today from that segment. I mean, they have some business in existing traditional nuclear facilities, but in terms of the small modular reactors, they don't really discuss it. I think personally it could be absolutely enormous in terms of the size of the market. If you just look at the UK, for example, the UK currently delivers roughly six gigawatts of nuclear power to the UK market today, six gigawatts. The UK government and many governments around the world are increasingly recognizing that their grids are strained.

48:04This is becoming very meaningful investment trend and political trend. Grids are strained and the more you put renewables into the system, the more they creak because of the intermittency of renewables. So you need good solid base load. What is that? It's coal, it's gas, it's nuclear. cause being phased out, so that leads you to gas and nuclear, and obviously nuclear is the one without the carbon footprint that's becoming an ever -increasing issue for everybody. So the UK government have a target by 2050 to get to 24 gigawatts of nuclear capacity versus six today. So a very meaningful step up.

48:44The most efficient way to get there is via small modular reactors. The difference between a small modular reactor and these big reactors that you see all around the world is the way that they're built. With a small modular reactor, you can build everything in a factory, in modules, literally think about create -sized modules that are very transportable. And you build each piece in the factory, then you transport it to site, then you put it together like a big jigsaw. That, if it's proven out on paper at the moment, is a much, much cheaper way to go and much more scalable. If you can get that to work on one or two, you can easily scale that up and it could become very, very efficient in terms of building a new capacity.

49:24If you need 18 gigawatt of energy just for the UK, that's 50 plus SMRs. That's just in the UK and they cost one half, two billion each versus 10 billion for the last runaway, horrific cost project in the UK in terms of the last nuclear build. So it could easily be a hundred billion market and that's just in the UK. and then scale that globally and you're into the trillions. So a huge, huge market. So the only question is what margin can you make on it, what market share can you get there? Obviously massive questions, but Rolls Royce are a leader in this. They've got a lot of the regulatory approval already in the UK.

50:02I think they should win a mandate in the UK to push this forward. Then they become very much opposed to child of the business and then hopefully it goes from there. Are there many competitors in that space today? Yes. People see the opportunity, anyone with any capacity to do this, Westinghouse, etc. All the ones you might think about are in the running. Even if you can snatch 10 % market share of a trillion dollar or a 10 trillion dollar market becomes absolutely enormous in terms of the revenue potential versus the current size of the business today.

50:37And it's to allocate capital. We've touched on some of the challenges that they've had in terms of getting the operational efficiency, but capital allocation, maybe there's not a significant opportunity to allocate free cash flow into various things, but how would you grade or assess the capital allocation of the business? Yeah, to be seen. The core of the business is engineering excellence and that is still the core. What's happened recently is new management has come in and started to improve the business operationally. I think the results are far tangible, but the jury is still out in terms of the degree to which you can squeeze out operation improvements and make this a resilient and enduring business for the long term for society and for shareholders.

51:25Capital allocation, because you've not been in a position to assess what they do with free cash flow because there's been no free cash flow. That's an open question, but if you listen to what management is saying, they want to achieve investment grade status. They think they'll get that this year. That requires certain leverage levels, which they should easily hit given their current free cash for level soon. It requires EBITDA margins above certain levels, which they should easily hit as well, given where they are today. Once they get that investment grade status, then I think they'll continue to bring down debt, but their free cash flow should be meaningful at that point.

52:02I suspect in a kind of three to four billion pound range per year over the next four to five years. So very substantial eight, nine percent pre -castral yield. On what hopefully is, at its core, a very, very good business and one that is on an improving path. In terms of assessing management's success with the operational improvement, are there certain milestones that you are looking for? Or is there a certain time period where you think it will result in a fair measurement of whether it's a full year, a certain amount of quarters where you're seeing a shift in the trend line that you think is something concrete happening, anything that you are using as a measuring stick to evaluate that particular thing?

52:49One of the things we like about new management is that they have put out very clear targets themselves. There's still a lot of skepticism from investors and I think the market isn't reflecting fully the possibility that the management hit those targets. What we like about the current setup is that they have set out their own KPIs right down to explaining what they're doing in each division on the cost side, on the revenue decides to drive value and to drive efficiency through the business. We're monitoring every quarter the results of the different divisions, but I think management, their own harshest critic in this regard.

53:32You think there's any risks that we haven't discussed? I think it's been a fairly balanced conversation to be honest, but is there anything that we didn't touch upon that stands out as a risk to you? The big risk, of course, is that some fault in one of their key products. I wouldn't have put pandemic on the list of risks five, six years ago, but that was obviously a big hit as well. The tail events, you never see them coming, and that one might be number one on the list. We wrap these conversations up talking about the lessons that you can potentially pull out from a particular company and apply elsewhere.

54:08Do you think there's lessons that stand out about roles, Royce from your investment process? So the one thing I would say is that we already knew, but it really does reiterate the life of this investment. We originally invested in 2015 on a turnaround thesis. You lived through turnarounds and you realized just how hard they are. And they're especially hard in normal times. So when we invested 2015, we were tracking the progress of all of the things they were trying to do to improve efficiency then, and it was going much more slowly than we'd hoped. And as I mentioned paradoxically, it's the crisis that looked awful for the company and from the lens of most investors at the time that provided that burning platform as the CEO described it at the time from which to make the tough but necessary decisions to turn the business around.

54:58That was in hindsight a great opportunity to earn this business. At the point when the market was absolutely terrified and it was only seeing the downside. So key lesson might be that sometimes it's good to look at crises through a different lens, I would say, one that focuses on whether it can trigger structural changes that can drive significant value out over time for the business. This has been a joy to learn about and I think we cover many companies that are several years past that turnaround or even decades past that turnaround and we're mostly analyzing a success story, their survivorship by involved here very much in the midst of something that's trying to go through that change.

55:39So appreciate the perspective and appreciate all the knowledge around the business and the industry. Thanks Matt. Much a lot of fun. Thank you. To find more episodes of breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary check out join Colossus .com. That's J -O -I -N -C -O -L -O -S -S -S -U -S .com.