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Questor: Rolls-Royce’s new engine is a game changer – buy before shares fly away
Questor share tip: The engineering company should be boosted by Nato members’ increased spending on defence
Today we introduce the latest recruit to the Questor team. Robert Stephens has worked as a share analyst in the City and now runs his own research firm. He holds the highly sought-after Chartered Financial Analyst qualification and is a keen investor on his own account.
Within the next 20 years the number of aircraft in our skies is forecast to more than double to almost 50,000 – and such rapid growth could provide a tailwind for Rolls-Royce. The company’s civil aerospace division contributes 53pc of sales and has the potential to adapt to an evolving marketplace that focuses to a greater extent on fuel efficiency and narrow-bodied jets.
While the company’s UltraFan engine is not expected to make its debut until the mid-2020s, it has the potential to significantly increase the size of the market that Rolls is able to address. At present the business focuses solely on engines for larger, “wide body” aircraft.
The UltraFan engine could be a game changer for Rolls, thanks to a scalable design that will also make it suitable for smaller, “narrow body” jets. Of the 37,000 or so new aircraft expected to take to the skies over the next 20 years, the vast majority are thought likely to be narrow bodied.
Since the UltraFan is expected to be 25pc more fuel efficient than the earliest version of the company’s Trent engine, it may also prove popular at a time when reduced emissions and cost advantages are likely to become increasingly important to airlines.
But this is not only in the civil aerospace sector that Rolls-Royce could have a brighter future.
Growth in its defence business looks likely to be boosted by increased military spending by the members of Nato. Those nations are supposed to spend a proportion of their economic output on defence, so growth in GDP should mean more spending on their armed forces and hence, other things being equal, more orders for companies such as Rolls.
The IMF has forecast world economic growth of 3.9pc in 2018 and 2019, while the eurozone (which accounts for a significant proportion of Nato members) is expected to grow by 2.2pc in 2018 and the US by 2.9pc. Nato members agreed at a summit in 2014 to implement a long-standing aim to spend 2pc of national output on defence.
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This was intended to rebalance Nato spending away from the US, which currently spends 3.6pc of output on defence, and towards the 23 members that spend less than 2pc of GDP. Donald Trump recently said the 2pc guideline should be doubled for all Nato members.
America itself plans to raise defence spending by 7.6pc in 2019, which could have a significant impact on total demand within the defence industry.
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Alongside two markets that are ripe for growth, Rolls’ financial performance could be boosted by a restructuring programme that will see 4,600 staff made redundant. It is on target to deliver savings of £400m a year by 2020, while a simplification of its business model has seen the disposal of its injection technology unit.
It has also announced the sale of its commercial marine unit as it moves towards a leaner operating structure.
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Management has been focused on overcoming disruption caused by problems with its Trent 1000 and Trent 900 engines. The annual cost of remedial measures is expected to be £450m this year and next, and £350m in 2020.
By 2022 the company aims to have fully embodied all the technical changes required in all engines of both types in service. Despite such costs Rolls expects to produce free cash flow of around £1.2bn in 2020. This would be an increase of 167pc from the £450m forecast for 2018.
Over the medium term it aims to generate £1.8bn a year in free cash flow. This could help to raise dividends; the yield is now a rather disappointing 1.2pc. Likewise, improving financial performance could help to justify a share price multiple that, at 24 times historic earnings, is by no means cheap.
In the near term the business is experiencing a period of rapid change, which could cause turbulence in its share price. The long-term growth potential in the defence and aerospace industries, however, suggests that there is every prospect of a soaring share price.
Questor says: buy
Ticker: RR
Share price at close: 929.8p