Wednesday, August 2, 2017

Rolls-Royce Investors Stop Believing in Turbulence: Shares of jet engine maker Rolls-Royce are on a tear; investors don’t seem to think anything can go wrong

The Wall Street Journal
By Alex Frangos
Aug. 1, 2017 10:06 a.m. ET

Aircraft engine maker Rolls-Royce is flying high—and its stock even higher.

The British company, which will forever be confused with a separate one that makes motorcars for billionaires (the automotive brand is owned by BMW ), has been on a tear after troublesome years of operational missteps and a major bribery scandal.

Chief executive Warren East, who arrived two years ago, has done an able job putting the company back on course. The arrival of long-term activists ValueAct into the share register and onto the board of directors gave the revamp story legitimacy.

First-half results out Tuesday confirmed things are going well in the company’s main business of selling and servicing jumbo jet engines. It delivered more engines and got more revenue from maintaining existing ones. Air traffic remains high, boosting its business model of selling engines at a loss while making money servicing them. Cost-cutting is also on target.

Crucially, free cash flow, adjusting for fines, was a less-than-expected outflow of £339 million. That excites investors who are banking on Rolls’ long-term trajectory. There is a record order backlog at Airbus and Boeing , and Rolls is set to control half the market in supplying widebody jet engines. Right now, it is in investment mode, building those engines. Once in service, they turn into cash machines.

The company aspires to generate £1 billion of free cash flow annually around 2020. Speaking to analysts Tuesday, Mr. East may have been trying to temper expectations by being vague about the timing, but he ended up winding them up by saying it could be achieved ahead of schedule—if everything goes right.

Everything going right means several things. Air traffic globally needs to grow at the current above trend high single digit rates, creating ample maintenance work for Rolls. Airlines have to not cancel big orders. And, most importantly, Rolls needs to execute on delivering engines with minimal trouble. Earlier-than-expected fixes to its Trent 1000 engines are manageable in terms of cost—but a reminder that things do occasionally go wrong.

Investors, however, don’t seem to think that way. A consensus free-cash flow yield of around 5% for 2020 seems to pack in a full dose of optimism. And on earnings-related valuation, after shares shot up 9% Tuesday and 45% this year, Rolls-Royce’s enterprise value is 10.6 times earnings before interest, tax, depreciation and amortization, the highest ever. They are expecting a flawless flight.

Original article can be found here ►

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