2018 London Sohn: Luke Newman Full Notes – Long Idea – ValueWalk Premium
Rolls-Royce 2018 London Sohn Luke Newman

2018 London Sohn: Luke Newman Full Notes – Long Idea

Full notes of Luke Newman, the Fund Manager of Janus Henderson Investors, from the 2018 London Sohn Conference.

Q3 hedge fund letters, conference, scoops etc

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Rolls-Royce 2018 London Sohn Luke Newman

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Check out more notes from the Sohn Conference below.

Good afternoon. Little could I have known when I was first asked to present here back in the summer, the most challenging part about this whole endeavor, have been a week long gap between submitting my presentation and being on stage here to present it to you. Because the volatility we’ve seen in markets have made that a very stressful period indeed. Thankfully the CEO in question bought shares in their company a few days ago, so it makes it onto a very short list of companies that I can be pretty confident about their trading at the moment. Now, as Paddy said, I run the long short funds at Janus Henderson. And our approach is to combine shorter term tactical [inaudible] to deal with the volatility we’ve experienced this year with more advertently fundamental core ideas, and we’re really looking to drive the performance for our investors. Now, sometimes those ideas take the form of turnaround situations, perceived broken companies that with the capitalist of a new management team or a new strategy can confound the past, can deliver through the passage of time better operating performance, investor sentiment can change. And ultimately, we look for valuation approaches towards a change.

So, my idea is long Rolls-Royce, not that one, this one. Now, Rolls-Royce separated from the car company back in 1972. And it was a series of mismanaged new program developments that actually caused big losses and the company had to be nationalized before it was then reprivatized back into the public market. So, in some ways the problems of Rolls Royce in the past actually demonstrate [inaudible] what the opportunities are going forward. And it’s hard, Rolls-Royce is a razor and razor blade model, but you need to think about razors on an industrial scale. Imagine razors cost billions of dollars to design, to produce and to deliver and install. And imagine that razor obligation to buy for the next 25 years a series of razor blades that were at effectively 50-70% gross margin to produce a Rolls-Royce, that really is at the heart of what Rolls-Royce are trying to do. And it’s made easier by the market that they operate within. And actually, it’s made easier because of our collective demand to travel by air. In recent years wealth effects and emerging market demand again have driven this demand to fly. And it’s as true for wide bodies as it is for narrow bodied, passenger kilometers over the last 70 years have grown in 6% cap, even when you adjust for some of the political [inaudible] crises that we’ve seen over that period, the resilience is staggering.

Now, [inaudible] on a board member of a large US financial, that the secret to corporate success was to think about an analogy using canoes. He said, “You didn’t need the fastest canoe and you didn’t need the most skillful canoeist, you needed to have your canoe in the fastest stream.” Now, I think he was talking about the demand for ETFs and passives at the time, but it applies equally well, I think, to all the companies that participate within the civil aerospace sector. Let’s put some numbers around this. There are 5,000 wide body planes installed globally currently. Assume those planes have a 25 year life, so we need to replace [inaudible] of them per annum, and assume we need to grow our fleet to keep up with that demand. Not at the 6%, we need to adjust for larger planes, and for increased load factors, so let’s grow that 4½%. That means we need 425 new wide bodied planes every year, that’s 8,500 over the next 20 years, which if you work backwards accounts for 37 new wide bodied planes every month. Have a look at the production schedules for Boeing and Airbus next year, they’re stated to produce 34. So, there’s some real friction within this industry and that creates positive pricing dynamics for all of the participants.

So, the challenge for Rolls-Royce is a relatively simple one. Can you deliver new technology that allows your customers to experience greater power, greater efficiency, greater range, install those engines will be at a loss and then execute effectively on the 25 years of high margin service revenues to generate a high [inaudible] profit. Sounds simple, apparently not. This is the share price of Rolls-Royce over the last five years and you can see [inaudible] from a slight pickup in the last 18 months, it’s been hard work. Something has not translated from these positive macro dynamics, and indeed, positive micro dynamics through to the return to the shareholders. So, what has gone wrong?

That’s the question for this man. And if you don’t recognize him, he’s the CEO of Rolls-Royce, Warren East. Now, there’s three things you need to know about Warren East. Firstly, he plays the organ in his local church. Secondly, he was the CEO of ARM Holdings from 2001 to 2013, probably the preeminent UK technology of recent years. And the third thing you need to know about Warren is when that company was acquired by Softbank, rather opportunistically after the Brexit vote, he gave half of his remaining shares that he owned with the company to charity. So, we’re talking here about a good man, but we’re also talking about a good businessman. And his aims are very clear at the moment, and I’ll say he’s got two. Firstly, it’s execution, the orders for those new engines have been secured. Can they be installed into the market and then can the execution in terms of working to plan and then getting to execute on those service revenues come through? Launching new engines is difficult, particularly when you’re Rolls-Royce. The XWB engine, which was the sole source of Airbus’s very successful A350, which has taken a huge of amount of share is a good example. You end up running with dual running cost, we call them stairs and [inaudible] labor because you need to ensure that those engines enter service in exactly the right moment. So, execute on the opportunity and the orders that were already in place.

The second one is an organizational one. Warren used to describe Rolls-Royce when he took the job as an athlete that needs to lose weight. And he’s put the company on a very strict diet ever since. We’ve seen a new FD, a new CEO, new divisional heads all of which have made their marks. We’ve seen a huge cost reduction plan announced earlier this year, 25% of modern engineering head count, that’s 4,500 people will be leaving the company, creating an ongoing benefit to Rolls-Royce. We’ve seen disposals of companies that wouldn’t make the grades, they wouldn’t in time reach the critical mass to be a good enough business for Rolls-Royce. And most of the players have been cash consumptive and loss making as well, so that’s been another source of operational improvement. And finally, he’s holding this business to account. Rolls-Royce is a company that’s always relied on its high levels of technology and its market share gain rather than being held to the financials. Rolls-Royce is currently a cash neutral business in terms of cash generation, the new targets with Rolls-Royce generating a billion sterling of cash flow by 2020 and an increase to 1.8 billion by 2023/24.

So, let’s look again at the opportunity that presents itself to Rolls-Royce right now. This industry has changed dramatically over the last 20 years, what was a three player market has become a jalopy. Pratt & Whitney took the rational decision to concentrate on the narrow body engines rather than the wide body, and ceded that market share to Rolls-Royce, that didn’t come through billions of dollars of development on new engines were involved in terms of taking that share for Rolls-Royce to find itself where it is today. And why is today so exciting? This year is the first year, the majority of revenue for Rolls-Royce within its aviation business will come from the aftermarket business, at very high margins as opposed to that loss making [inaudible]. So, it’s a critical inflection point for the company, contrast that to the other member of the jalopy, GE. Now, for all GE’s problems, the aviation business has not been one. They’ve been in harvest mode, maintaining share, and having a much bigger SKU and a much more mature fleet to those aftermarket revenues. And what is the cost to that market share gain? Well, it’s evident both ways, if you look at GE’s aviation’s margins, they’ve been able to maintain over the last 20 years, they’ve been incredibly high, compounding and growing whilst harvesting those returns.

And just look at Rolls-Royce, and in particular look at the dotted red line at the bottom. That’s Rolls-Royce aviation reported under IFRS 15, that strict sounding early recognition of those aftermarket contracts so we can use it as a proxy for cash to see just how expensive it’s been to take those shares. And the business itself was in a cash consumptive period in as recently as 2016. The future, as we’ve discussed looks a lot more encouraging. The company targets a 15% EBIT margin target as the [inaudible] effect begins to work in its favor.

We’ve spent the last 10 minutes looking at as much as you can in 10 minutes, the business model of Rolls-Royce. But if I was to show you just one chart, this will be it. And equally if you wanted to understand Rolls-Royce more as a business, there is a share price, and at the end of the day that’s what our focus is, this is the slide that I would look at. There’s been an undeniable correlation over the years between the free cash flow, a share that Rolls-Royce have generated and the share price itself. So, let’s think about the target that the company have given us, 1.8 billion] by 2023, that equates to just under [inaudible] a share. So, if this previous correlation can hold and the company can execute then we’re looking at considerable upside for these shares. How do you bridge the gap between generating no cash today and that £1.8 billion? It’s in three ways, firstly that mix effect is incredibly powerful, executable on the install base should mean that Rolls-Royce would benefit to the tune of £700-900 million in cash flow every year as they move forward over the next five years. The cost cutting plan we mentioned, should see around 400 million of incremental cash flow on an annualized basis to the benefit of Rolls-Royce. And finally, those early losses, I’ve said it’s a truism of the moral of Rolls-Royce that you sell new engines and [inaudible] later, but that doesn’t mean that Rolls-Royce [inaudible] will be complacent. Every engine currently costs Rolls-Royce, £1.6 million, within five years that should be reduced to under half a million. What does that mean at group level? It means that the company should be £500 million of free cash flow a year better off.

So, we can see the mechanism of the proposal. How would we know the company and the management team are focused on the same things that we are as shareholders? And this is where I like to look at the incentivization of the companies that we invest in. This is simply a screen print from the 2017 Rolls-Royce report accounts. The thing that jumps out to me about this picture is just how high the alignment within the long term incentive plan is to catch CPS, Cashflow Per Share, 60%. And I’m struggling to think of another company that I’ve seen that has aligned its executives quite so closely to the cash flow of the [inaudible]. How will the executives max out on this investment plan? They will need to generate 158p of the cash flow in the financial years 18, 19 and 20. What is consensus expecting currently? 117p, so there’s a 35% upside to the stretch target that the board and the remuneration committee feel that the executives of Rolls-Royce can achieve, and achieve, even if you’ve got to the mid-point of a new range, that’s going to [inaudible] its upside to the consensus. So, I think when [inaudible] of this company, because the future is so very different to the past, there’s been a lag in terms of understanding just how cash generative this business will be.

So, putting all that together, what is Rolls-Royce worth? And I’ve taken both of the companies targets in terms of a billion in 2020 and then a higher target in 2023/24. And first of all, let’s just assume that the market doesn’t really like Rolls-Royce, let’s assume that it turns up in 2020 and [inaudible] is there on the same multiple that it finds itself today, around 6% free cash flow yield, there’s upside then, considerable upside from the current 15 billion of market cap today. And note that I’m only looking at the market cap calculation here. If we looked at the cash as EV, because the cash build for Rolls-Royce would be so high then, we’d end up with an even more extreme upside and we factor in optionality around the cash returns. But let’s dream the dream, let’s look at the wider aerospace sector, and let’s look at companies like Safran and MTU, where delivery are meeting or beating expectations, has led to a re-rating in the shares, or in this case a yield compression in terms of free cash flow yield and to use current trading of 2.9 times free cash flow yield for next year. So, Rolls-Royce on a 4% free cash flow yield and that stretch target out till 23, could see upside of up to 300% in terms of the share price with a notion share price target undiscounted of around £24 [inaudible]. So huge amounts of upside for a large cap company.

And I think the exciting thing to me is that here is a large cap company where the hard work has already been done. The challenge is to execute on the install base in an efficient manner and then enter the tipping point of the high margin controversy. To leave you with one final thought, I mentioned the canoeing analogy earlier. And certainly, the fast stream that Rolls-Royce finds itself in is a benefit to Rolls-Royce and its peers. But imagine if you had the fastest, most efficient canoe and a canoeist that can play the organ, then that’s so much better.

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