Margin disappointments and increased earnings volatility in Rolls-Royce’s Civil Aerospace business bring the pricing of the backlog into question. Ceteris paribus, margins will improve from now, but the competitive threat from GE Aviation cannot be ignored. Nor can the long-term risk that Rolls-Royce may attempt to re-enter the narrow-body market. We downgrade to Neutral.
* Under pressure. Civil Aerospace margins will rise naturally over the next five years, but accelerating cost-cutting will be difficult. Much rests on the success of the Trent XWB. Concerns over the pricing of long-term contracts are difficult to address.
* The GE factor. GE Aviation’s scale and margins (Fig 1) are not easily replicable. The same positive dynamics that could boost Rolls-Royce’s Civil Aerospace margins will give GE Aviation the firepower to become an aggressive market leader.
* The narrow-body conundrum. Re-entering the narrow-body market would be expensive and difficult, but this is a large segment of the market Rolls-Royce cannot ignore. A decision is not imminent, but this could necessitate significant investment just at the point when Rolls-Royce starts to generate a meaningful amount of cash.
* What is Rolls-Royce worth? Rolls-Royce is very expensive on a multiples basis, with no meaningful recovery in EPS or FCF until 2019. Fair value now is 850-900p, based on the mid-point between embedded value (930p) and P/E approaches (750p at 15x 50p). Rolls-Royce’s value to a trade buyer would be materially higher
(>1,250p), but we view a takeover as possible (though unlikely).