Rolls-Royce (RR.) reported 2013 results that reflected solid revenue growth of 27% (6% excluding the power systems unit). Adjusted profit also improved, though margins were hampered by the inclusion of lower-margin Tognum, resulting in a margin decline of 40 basis points to 11.8%. For 2014, management expects flat revenue growth and profit growth, which would stunt our earnings projections for the company.
The defence spending environment remains weak, which should result in lower potential revenue for Rolls-Royce. We also suspect the company will need to recalibrate its aviation effort after exiting the International Aero Engines joint venture with Pratt & Whitney. We are leaving our fair value estimate unchanged at £10.60 per share as the weak near-term forecast offsets the increase related to the impact of the time value of money on our valuation model. We maintain our narrow economic moat rating.
Rolls-Royce 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 – defence spending is coming under pressure globally and the company lacks a presence in the next generation of commercial narrow-body aircraft.
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 weighed down operating margins, 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 accretive.
