Rolls-Royce: Turbines and Tribulations

Sector

Aerospace & DefenceAutosIndustrials

Background

Graeme Forster is a Portfolio Manager at Orbis Investments. We cover the history and pedigree of the Rolls-Royce brand, what making aircraft engines has in common with insurance businesses, and the company's approach to R&D in growth areas such as wind turbines.

Cover

Date

July 17, 2024

Episode Number

174

Business Breakdown: Rolls-Royce Holdings

Background and Overview

Rolls-Royce Holdings, a publicly traded British company founded in 1906 by Charles Rolls and Henry Royce, is a global leader in high-value, low-volume power systems, primarily known for its aerospace engines. Originally a car manufacturer, the company shifted focus to aerospace and other industrial power systems after the car division was spun off in the 1970s due to financial distress from the mismanaged RB211 engine project, which led to nationalization. Today, Rolls-Royce operates in Civil Aerospace (50% of revenue), Power Systems (25%), Defense (25%), and New Markets, with a focus on engineering excellence and innovation. The company employs approximately 40,000 people and is headquartered in London, UK. Its culture, rooted in Henry Royce’s obsession with quality, emphasizes precision and reliability, which remains a cornerstone of its competitive positioning.

Ownership and Valuation

Rolls-Royce Holdings is publicly traded on the London Stock Exchange (LSE: RR). The transcript does not provide specific details on recent valuations, enterprise value (EV), or transaction multiples, but it notes that the company raised significant capital during the COVID-19 crisis to survive a near-total revenue collapse due to grounded planes. Management aims to achieve investment-grade status in 2025, suggesting a focus on reducing leverage and improving financial stability. The lack of historical free cash flow (FCF) generation makes valuation challenging, but the potential for GBP 3-4 billion in annual FCF over the next four to five years implies an 8-9% FCF yield, indicating a potentially attractive valuation if operational improvements are realized.

Key Products, Services, and Value Proposition

Rolls-Royce’s core value proposition lies in delivering high-performance, reliable power systems for mission-critical applications. Its primary products and services include:

1. Civil Aerospace (50% of revenue):
• Large Aircraft Engines: High-thrust engines for wide-body, twin-aisle planes (e.g., Airbus A350, Boeing 787) used in long-haul passenger and freight transport. Rolls-Royce holds a 50% share of new orders and 30-40% of the installed base.
• Business Jet Engines: Smaller engines for private and corporate jets, a high-margin niche.
• Value Proposition: Superior engineering ensures fuel efficiency, reliability, and long service life (up to 30-40 years). Long-term service agreements (LTSAs) provide sticky, high-margin aftermarket revenue.
2. Power Systems (25% of revenue):
• Off-Highway Engines: Large engines for marine vessels, trains, and industrial machinery.
• Energy Production and Storage: Gas turbines and battery storage systems for power generation, benefiting from data center growth.
• Value Proposition: Versatile, durable power solutions for industrial applications, with moderate aftermarket revenue.
3. Defense (25% of revenue):
• Military Power Systems: Engines for air, land, and sea, including nuclear propulsion for UK submarines.
• Value Proposition: Mission-critical reliability for defense applications, with stable government contracts.
4. New Markets:
• Small Modular Reactors (SMRs): Factory-built, scalable nuclear reactors for power generation, leveraging expertise from submarine propulsion.
• Value Proposition: Potential to address global energy demands with cost-effective, low-carbon nuclear solutions. The UK market alone could require 50+ SMRs (GBP 100 billion), with global potential in the trillions.

Segments and Revenue Model

Rolls-Royce operates four economically separable segments, each with distinct revenue models:

1. Civil Aerospace:
• Revenue Model: Approximately one-third of revenue comes from original equipment (OE) sales to airframers (e.g., Airbus, Boeing) at low margins. Two-thirds comes from high-margin LTSAs, where airlines pay per flight hour for maintenance and repairs over 10-13 years. LTSAs are akin to insurance contracts, covering scheduled overhauls, part replacements, and tail events (e.g., engine failures).
• Key Dynamics: The aftermarket-driven model ensures sticky, recurring revenue, but profitability hinges on pricing LTSAs correctly and controlling maintenance costs. The business benefits from GDP-plus growth in air travel demand.
2. Power Systems:
• Revenue Model: A mix of OE sales and aftermarket services, with less emphasis on long-term contracts compared to Civil Aerospace. Revenue is generated from selling engines and turbines, plus maintenance and spare parts.
• Key Dynamics: Moderate aftermarket revenue provides stability, but margins are lower than Civil Aerospace due to less sticky service contracts.
3. Defense:
• Revenue Model: Primarily OE sales to governments, with some aftermarket services. Contracts are often long-term and volume-driven.
• Key Dynamics: Stable demand from defense budgets, but lower margins due to higher upfront sales focus.
4. New Markets (SMRs):
• Revenue Model: Currently negligible revenue, but future potential from selling and servicing SMRs.
• Key Dynamics: High capital intensity and regulatory hurdles, but a massive addressable market if successful.

Splits and Mix

• Segment Mix (Revenue): Civil Aerospace (50%), Power Systems (25%), Defense (25%), New Markets (0% currently).
• Customer Mix: Civil Aerospace serves airframers (Airbus, Boeing) and airlines (e.g., Lufthansa). Power Systems targets industrial and marine clients. Defense serves governments (e.g., UK Navy). SMRs will target utilities and governments.
• Geographic Mix: Not detailed in the transcript, but global exposure is implied, with strong UK presence in Defense and SMRs.
• Channel Mix: Direct sales to airframers and governments, with LTSAs negotiated directly with airlines.
• End-Market Mix: Aerospace (passenger/freight travel), industrial (marine, trains), energy (data centers, utilities), defense (military).
• Mix Shifts: Civil Aerospace is expected to grow faster than other segments due to air travel demand and aftermarket revenue. SMRs could become significant post-2030.

KPIs

• Market Share: 50% of new wide-body engine orders, 30-40% of installed base (growing).
• LTSA Renewal Rates: High stickiness, with renegotiations triggered by airline mergers or fleet changes.
• Time on Wing: Increasing through data analytics, reducing overhaul frequency and costs.
• Order Book: Robust due to undersupply post-COVID and GDP-plus air travel growth.
• Margin Improvement: Targeting high-teen margins in Civil Aerospace (from low teens) within 5-6 years.

Headline Financials

The transcript provides limited numerical data, but key financial insights include:

• Revenue: Not quantified, but Civil Aerospace (50%) is the largest contributor, followed by Power Systems and Defense (25% each). Revenue is driven by OE sales (one-third) and LTSAs (two-thirds) in Civil Aerospace, with steady growth tied to air travel demand (GDP-plus).
• EBITDA Margins: High single-digit to mid-teen across segments, with Civil Aerospace at low teens (targeting high teens). GE Aviation, a competitor, achieves low-20s margins.
• FCF: Historically lumpy and negative due to high R&D, capex, and LTSA mispricing. Management projects GBP 3-4 billion annual FCF in 4-5 years, implying an 8-9% FCF yield.
• Capex and R&D: Billions annually, with tens of billions for new engine programs. Current R&D is lower, with the next major program expected in the early 2030s.
• Table:

Metric	Current (2025) Estimate	Future Target (2030)
Revenue Growth	GDP-plus (~3-5% CAGR)	GDP-plus-plus (~5-7%)
EBITDA Margin	Low teens (Civil)	High teens (Civil)
FCF	Negative/lumpy	GBP 3-4B/year
Capex/R&D	Billions	Lower until 2030s

Value Chain Position

Rolls-Royce operates midstream in the aerospace and industrial power value chain:

• Primary Activities: R&D, manufacturing, and aftermarket services. The company designs and produces complex engines and power systems, then maintains them through LTSAs.
• Supply Chain: Sources high-precision components (e.g., turbine blades) and raw materials. Suppliers are concentrated due to the specialized nature of inputs.
• Go-to-Market (GTM): Direct sales to airframers and governments, with LTSAs negotiated with airlines. The GTM emphasizes technical superiority and long-term partnerships.
• Value-Add: Engineering excellence and aftermarket services capture significant value. The aftermarket is the most profitable part of the value chain, as OE sales are low-margin.

Customers and Suppliers

• Customers:
• Civil Aerospace: Airframers (Airbus, Boeing) and airlines (e.g., Lufthansa). Airlines are price-sensitive but value reliability and uptime.
• Power Systems: Industrial clients (marine, rail, data centers).
• Defense: Governments (UK, others).
• SMRs: Utilities and governments (future).
• Suppliers: Specialized component manufacturers. Supplier power is moderate due to concentration and differentiation, but Rolls-Royce’s scale provides leverage.

Pricing

• Contract Structure: LTSAs are 10-13-year agreements based on flight hours, covering maintenance, overhauls, and tail events. OE sales are fixed-price to airframers.
• Pricing Drivers:
• Mission-Criticality: Engines are critical to airline operations, justifying premium pricing.
• Customer Willingness to Pay: Airlines pay for reliability and uptime, but historical underpricing has hurt margins.
• Competition: Duopoly with GE limits price elasticity, but Rolls-Royce has lagged in capturing value.
• Mix Effects: Higher-margin LTSAs dominate Civil Aerospace revenue.

Bottoms-Up Drivers

Revenue Model and Drivers

• Civil Aerospace:
• OE Sales: Low-margin sales to airframers, driven by new plane orders. Volume is low (300 engines/year), but order books are robust due to post-COVID undersupply and air travel growth (GDP-plus, ~3-5% CAGR).
• LTSAs: High-margin, paid per flight hour. Revenue scales with flying hours, which track air travel demand. LTSAs cover 20-40 planes per contract, with high renewal rates.
• Drivers: Air travel growth (GDP-plus), undersupply of planes, increasing installed base (30-40% share), and time on wing (via data analytics).
• Power Systems: OE sales and aftermarket services, driven by industrial demand (e.g., data centers). Growth is steady but less dynamic than aerospace.
• Defense: Stable government contracts, driven by defense budgets.
• SMRs: No current revenue, but future growth depends on regulatory approval and market adoption.
• Mix: Civil Aerospace dominates revenue and profit potential due to aftermarket stickiness.

Cost Structure and Drivers

• Variable Costs:
• COGS: Materials, labor, and components for engine production and maintenance. Overhauls (every 4-5 years) are a major cost driver.
• Drivers: Inflation, procurement efficiency, and overhaul frequency. Data analytics reduce costs by extending time on wing.
• Fixed Costs:
• R&D: Billions annually, with tens of billions for new programs. Currently lower until the 2030s.
• Facilities and Overhead: Manufacturing plants, service centers, and admin. Consolidation efforts are reducing costs.
• Drivers: Economies of scale and operating leverage. Fixed costs are high, but revenue growth can improve margins.
• Contribution Margin: High in LTSAs due to low variable costs post-OE sale. OE sales have low contribution margins.
• Gross Margin: Not specified, but implied to be lower than GE’s due to inefficiencies.
• EBITDA Margin: Low teens in Civil Aerospace, targeting high teens through cost cuts (procurement, labor, facilities) and better LTSA pricing.

FCF Drivers

• Net Income: Limited by historical mispricing and high R&D/capex.
• Capex: Billions annually, split between maintenance (facilities, service centers) and growth (new engine programs). Lower capex expected until the 2030s.
• Net Working Capital (NWC): Negative due to upfront LTSA payments, improving cash conversion. Cash conversion cycle is short, as revenue precedes overhaul costs.
• FCF: Historically negative due to lumpy capex and LTSA losses. Projected GBP 3-4 billion annually by 2030, driven by margin expansion and revenue growth.

Capital Deployment

• M&A: Limited activity due to capital constraints. Future M&A could target SMR technology or adjacent markets.
• Organic Growth: Focus on improving existing segments and developing SMRs.
• Debt Reduction: Priority to achieve investment-grade status, reducing leverage.
• Buybacks/Dividends: Unlikely until FCF stabilizes.

Market, Competitive Landscape, and Strategy

Market Size and Growth

• Civil Aerospace: The wide-body engine market is worth tens of billions annually, growing at GDP-plus (3-5% CAGR) due to air travel demand. Post-COVID undersupply boosts growth to GDP-plus-plus (5-7%) over the next 5-7 years.
• Power Systems: Driven by industrial and data center demand, growing at ~3-4% CAGR.
• Defense: Stable, tied to government budgets (~2-3% CAGR).
• SMRs: Potential GBP 100 billion market in the UK, trillions globally by 2050, driven by nuclear demand (24 GW target in the UK vs. 6 GW today).
• Industry Growth Stack: Air travel growth is driven by population growth, wealth creation (e.g., <10% passport penetration in China/India), and supply constraints.

Market Structure

• Civil Aerospace: Duopoly with GE, with Rolls-Royce holding 50% of new orders and 30-40% of the installed base. High barriers to entry (tens of billions in R&D) limit competitors. Minimum efficient scale (MES) is large, supporting only a few players.
• Power Systems: Fragmented, with competitors like Caterpillar. Lower MES allows more players.
• Defense: Oligopolistic, with stable government contracts.
• SMRs: Emerging, with competitors like Westinghouse. Regulatory approval is a key barrier.

Competitive Positioning

• Civil Aerospace: Strong position due to scale, engineering excellence, and LTSA stickiness. Exclusive contracts (e.g., Airbus A350) enhance positioning. Weakness lies in lower margins vs. GE.
• Power Systems: Competitive but less differentiated, with moderate market share.
• Defense: Strong in niche applications (e.g., UK submarines).
• SMRs: Early leader in the UK, with regulatory advantages.

Hamilton’s 7 Powers Analysis

1. Economies of Scale: High in Civil Aerospace due to large MES. Producing 300 engines/year requires significant scale, deterring new entrants.
2. Network Effects: Limited, as engines are standalone products.
3. Branding: Strong Rolls-Royce brand signals quality, but less impactful in B2B markets.
4. Counter-Positioning: LTSAs create a superior business model, locking in airlines. GE matches this model, reducing differentiation.
5. Cornered Resource: Proprietary technology and data analytics for engine maintenance provide an edge.
6. Process Power: Engineering excellence and data-driven maintenance optimize performance, but historical missteps (e.g., Trent 1000) highlight risks.
7. Switching Costs: High due to LTSA stickiness and infrastructure. Airlines rarely switch providers mid-contract.

Competitive Forces (Porter’s Five Forces)

1. New Entrants: Low threat due to high barriers (R&D, scale, regulatory approval).
2. Substitutes: Low threat, as jet engines have no direct substitutes for wide-body planes.
3. Supplier Power: Moderate, as specialized components limit supplier options, but Rolls-Royce’s scale mitigates this.
4. Buyer Power: High, as airlines negotiate LTSAs aggressively. Airframers (Airbus, Boeing) have moderate power due to duopoly dynamics.
5. Industry Rivalry: Moderate in Civil Aerospace due to duopoly, higher in Power Systems due to fragmentation.

Strategic Logic

• Capex Cycles: Defensive capex to maintain engine reliability, with offensive R&D for next-generation engines (early 2030s). Lower R&D spending currently preserves cash.
• Vertical Integration: Limited, as Rolls-Royce focuses on engines, not airframes or components.
• Horizontal Integration: Potential in SMRs to diversify revenue.
• MES: Achieved in Civil Aerospace, but overexpansion risks diseconomies of scale (e.g., bureaucracy).
• Turnaround Strategy: New management (since 2022) leverages the COVID crisis to cut costs, renegotiate LTSAs, and improve margins, capitalizing on a “burning platform.”

Unique Business Model Dynamics

Rolls-Royce’s business model is distinguished by several unique dynamics:

1. Aftermarket-Driven Revenue: The Civil Aerospace segment’s reliance on LTSAs (two-thirds of revenue) creates a high-margin, sticky revenue stream akin to insurance. Paying per flight hour aligns costs with usage, providing predictability and scalability.
2. Long Asset Life: Engines last 30-40 years, with LTSAs spanning 10-13 years, creating long-tail revenue and high switching costs.
3. Data-Driven Maintenance: Real-time data analytics extend time on wing, reducing overhaul costs and boosting LTSA profitability.
4. Duopoly Advantage: The wide-body engine market’s duopoly with GE ensures stable market share and pricing power, though Rolls-Royce has historically underperformed on margins.
5. SMR Potential: The pivot to SMRs leverages existing nuclear expertise, offering exposure to a trillion-dollar market with minimal current investment.
6. Historical Missteps: Underpricing LTSAs and engineering issues (e.g., Trent 1000) highlight a cultural bias toward engineering over commercial discipline, a key area for improvement.

Key Takeaways

• Revenue Trajectory: Steady GDP-plus growth (~3-5% CAGR) in Civil Aerospace, boosted to 5-7% by post-COVID undersupply. LTSAs drive two-thirds of revenue, with high stickiness.
• Cost Trajectory: High fixed costs (R&D, facilities) offer operating leverage if revenue grows. Variable costs (overhauls, materials) are being optimized via data analytics and procurement.
• Profit Margins: Low-teen margins in Civil Aerospace (vs. GE’s low 20s) target high teens through better LTSA pricing and cost cuts.
• Capital Intensity: Billions in R&D and capex, but lower until the 2030s. Negative NWC improves FCF conversion.
• FCF: Historically lumpy, but projected GBP 3-4 billion annually by 2030 (8-9% yield) if turnaround succeeds.
• Market Overview: Civil Aerospace benefits from a duopoly and GDP-plus growth. SMRs offer a massive, long-term opportunity.
• Valuation: Attractive if FCF targets are met, but risks include engine faults and execution challenges.
• 7 Powers: Strong economies of scale, switching costs, and process power, but counter-positioning is matched by GE.
• Unique Dynamics: LTSA-driven revenue, long asset life, and SMR potential set Rolls-Royce apart, but commercial discipline is critical to unlocking value.

This detailed breakdown highlights Rolls-Royce’s complex but potentially rewarding business model, with significant upside if management executes its turnaround strategy effectively.

Transcript