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In keeping with management’s revised July guidance, narrow-moat Rolls Royce (RR.) reported rough 2015 results that were primarily driven by weakness in the defence aerospace and marine operating segments. Underlying revenue declined 4% to £6.8 billion, 1% on a constant-currency basis, versus the prior period, resulting in operating margin contraction of 130 basis points to 12.1% in 2015.
Narrow-moat Rolls Royce benefits from high customer switching costs
A 4% increase in service revenue, led by the civil aerospace, was more than offset by a 5% decline in revenue from original equipment. Research and development costs increased by 11% over 2014, largely reflecting ongoing investment in civil aerospace from the Trent 100 and Trent XWB, together with higher spending on the Trent 7000 and corporate jet programs. We are updating our valuation for the latest developments, but we don't expect major changes to our fair value estimate, as 2015 results were largely in line with our expectations.
Rolls-Royce continues to gain market share in installed thrust; as a result, the company should benefit from increased demand for aftermarket services. However, as we indicated in our November 2015 note, we have begun to see reduced utilisation by some specific operators of older wide-bodied engines. This management of short-term excess capacity, as the market takes delivery of newer, more fuel-efficient airplanes, will affect aftermarket revenue and profit in 2016. However, we maintain the firm's narrow moat, as we see the issues as cyclical rather than structural in nature.
The main highlight of 2015 results, in our view, was the £12.8 billion order intake for civil aerospace, up £1.1 billion on the previous year. As a result, the order book closed at £67 billion, up 6% on the previous year. Significant orders included the order to provide Trent 900 engines and TotalCare service support for 50 Airbus A380s for Emirates, worth $9.2 billion, of which $6.1 billion is recognized within the order book.
While long product cycles in the aerospace industry often plague engine manufacturers with lumpy revenue, we believe that narrow-moat Rolls Royce benefits from high customer switching costs. Once an engine is installed, customers rely on recurring maintenance services to keep these important pieces of equipment functioning properly, and are reluctant to switch manufacturers after heavy investment in a specific technology. This dynamic, which we believe provides the foundation of Rolls Royce’s narrow economic moat, should continue to protect the firm’s ability to generate attractive returns on invested capital over the long run.
In line with our previous expressed expectation, Rolls Royce reduced shareholder payments for the first time in almost 25 years. As a result, the final payment for 2015 is £0.071 per share, a 50% reduction from 2014's final payment. The interim payment for 2016 will also be reduced to 50% of 2015's interim payment.
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