Rolls-Royce (
RR.) is one of only four firms in the world that can successfully develop and manufacture commercial narrow-body jet engines, a key reason we think the company stands to benefit from sizable competitive advantages in its end markets. That said, we see a few growth headwinds for Rolls-Royce--defense spending is coming under pressure globally and the company lacks a presence in the next generation of commercial narrow-body aircraft.
Alliances and joint ventures abound in the commercial aerospace engine market, where a partner on one platform may be a competitor on another. Each firm is fully aware of the others' technologies. Competition, though fierce, provides an adequate return for firms investing in new platforms. Rolls-Royce's Trent engines have carved positions on a number of major commercial airframes, including the Boeing 787 and Airbus' A380 and A350 platforms. Each of these platforms should produce steady demand for Rolls-Royce in the coming years.
Rolls-Royce's absence in next-generation commercial narrow-body airframes is its most glaring weakness at the moment. We think the bulk of aircraft deliveries will continue to flow to the narrow-body frames, leaving firms that cater to larger aircraft out of the party. We find Rolls-Royce's inability to find a place on a narrow-body airplane eerily reminiscent of Pratt's decision to focus on wide-body planes while letting GE have free reign on the narrow-body fleet three decades ago. While it is too early to tell whether the strategic decision makes sense, the precedent does not bode well for Rolls-Royce.
Rolls-Royce has attempted to leverage its aero-derivative engine technology into other areas, including marine applications and offshore energy power generation. While the marine segment has largely been beneficial to the firm, the energy segment has not, and we are concerned that the underperformance is limiting returns on capital for the firm in the near term. Though the longer-term strategy is to focus on energy applications, we think investors will have to wait for this bet to be profitable.
Rolls-Royce enjoys a better market penetration than its peers thanks a diverse set of competitive advantages. The high barriers to entry imposed by the technical knowledge required to design and manufacture a jet engine keep out many competitors. Continuously improving engine performance standards ensures that products are on a constant upgrade cycle, frustrating new competition. Rolls-Royce's customers, the airline operators, are hesitant to switch to new engines, since the change entails higher investment in spare parts and the expense of retraining maintenance personnel.
Long product cycles also ensure that a platform win brings in revenue for multiple decades. While Rolls-Royce has enjoyed stupendous success in civil aviation, it faces strong competition from Pratt & Whitney and GE for platform wins. Pratt and GE enjoy much higher levels of profitability, while Rolls-Royce's operating margin has varied between 4% and 13% in the past, dragging down ROICs and restraining the firm's competitive advantage.
Bulls Say
- Rolls-Royce is the only manufacturer with an engine ready for the A350 platform. As Airbus readies the plane for a 2014 debut, Rolls-Royce enjoys the first-mover advantage.
- Rolls-Royce will benefit from its presence on the Gulfstream G650, a model that boasts a five-year backlog.
Bears Say
- Rolls-Royce's single-digit operating margins compare poorly with those of Pratt & Whitney and GE.
- The firm still struggles to generate a profit at its energy business, which has proved to be a drag on profits.
- The firm's currency hedge book can produce volatile results and skew earnings in the short term.
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