Rolls Royce Appoints New CEO

Equity analysts approve of the appointment of Warren East as Chief Executive at Rolls Royce, but remain concerned about the corporate strategy

Morningstar Equity Analysts 22 April, 2015 | 4:27PM
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Rolls-Royce (RR.) named board member Warren East as chief executive officer, replacing John Rishton, who will retire on July 2 2015. Warren East was CEO of ARM Holdings from 2001 to 2013. Under his leadership we always viewed ARM as a well-run company, and a worthy steward of shareholder capital. Warren has been a nonexecutive director of Rolls-Royce since January 2014. We maintain our narrow economic moat, standard stewardship rating, and fair value estimate of £9.53 per share.

With Rishton at the helm, the company made reasonable capital allocation decisions, shunning lofty acquisitions and protecting returns on invested capital. Additionally, the management team consistently paid a dividend and repurchased shares, reflecting its commitment to returning excess cash to shareholders. For these reasons, we think Rolls-Royce merits a Standard Stewardship Rating.

However, we also expressed our concerns about corporate strategy. Rolls-Royce's management strategically chose to allocate capital and highly skilled labour to develop next-generation wide-body airframe engines at the expense of the narrow-body airframe arena. The firm currently has no narrow-body engine offering, and will not join the party until 2020-30, when new narrow-body platforms are going to be developed.  We believe this will limit sales growth, as the bulk of aircraft deliveries will continue to flow to the narrow-body frames.

Rolls-Royce is one of only four firms in the world that can successfully develop and manufacture civil and defence jet engines, and this is a key reason we believe it possesses a moat. The growing installed base of engines that have useful lives of more than 25 years results in a stable, long-term annuity of future services revenue. 

Rolls-Royce has attempted to leverage its aero-derivative engine technology into other areas, including marine applications, energy power generation, and power systems, which have structurally lower operating margins driven by limited aftermarket services revenue. Revenue contribution from the land and sea division will be muted in the short term. On top of continued price pressure resulting from current shipyard overcapacity, future volume growth will be limited in the marine market, given the weak order trends over the past three years.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Rolls-Royce Holdings PLC540.80 GBX2.77Rating

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