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Notes from the Road in Consensus-Short Europe

Speed Read:

  • Updates to Leonardo, Rolls-Royce and Flybe
    • Rolls is poised to dominate half the jet engine market
    • Leonardo’s divisions are absolutely crushing it, new CEO looming
    • Flybe’s growth profile moderation will enable >75% of its routes that are breakeven to grow profitability
  • We believe all three are well poised for the next three, six and twelve months

In the beginning of the year, a lot of focus is put on the top ideas for the next year. At the end of 2016, we figured our best positioned companies for 2017 were Telecom Italia and Bolloré. We still think both companies are well poised for the year ahead. Yet two months into the year, with Bolloré’s strong performance taken into account, along with all the other moving variables in our portfolio and force-rank list, two British companies and one additional Italian company have emerged as our favorite stocks for the next ten months: Rolls-Royce, Flybe and Leonardo.

Now, we should pause and say that our entire portfolio is always optimized for the most favorable opportunities at that very given moment. We spent our entire fourth quarter letter discussing how we view that as our essential purpose: to always offer a conglomeration of the best opportunities on a global basis whereby the entire portfolio is better than any individual component of the group. We’ve continuously honed our force-rank process in order to improve our near and medium-term chances of success as well as, of course, our long-term ability to generate highly satisfactory returns. Most recently, we’ve paid close attention to sentiment vs. reality, and particular attention to where consensus is baking-in extreme probabilities that are most obviously wrong. One of the most obvious areas where market probabilities and expectations are wrong, is the near-term breakup of the Eurozone. The most recent Barron’s roundtable, all of the members of which we respect deeply, were 100% on board with a eurozone breakup in the next year. While we don’t know the probability of the actual breakup, it’s somewhere between 20-80%, obviously not >95%.

In a similar vein, these three companies have completely apathetic and downtrodden expectations built into their stock prices and sell-side recommendations. They also happen to offer some of the most interesting upside potential in the short, medium and long-term. They are, all three, those rare birds where we find a completely negative market view juxtaposed to solid underlying operating performance.

We have long been convinced that 2016 would represent the operational bottom for Rolls-Royce. Now that the bottom is in place, and it came through a lot stronger than every single analyst (except yours truly ) had predicted, our estimates of downside potential have moved up considerably. In our model, which nailed the operating profit figure, we sensitize a 9/11 attack and a global recession into the Rolls model, and we still get extremely limited downside from here. We also believe the company is poised to beat current consensus profit estimates for 2017 by over 40%. Consensus and guidance are very conservative, sentiment on the stock is decidedly terrible (a great thing in our books), allowing most incremental news and catalysts from here to have a positive effect on the valuation.

We also believe many people are missing the accelerated spending and testing of the Advance engine, which will improve fuel economy by a minimum of 10% from today’s generation of engines, which are already the most efficient in the world. On a head-to-head basis, the Trent 1000-TEN is 2% more fuel efficient than the GENx, which alone is impactful. Should Rolls be able to pull forward Advance and create a 12-point spread to its only competitor, we believe Rolls would effectively dominate the wide-body engine market. We refrain from using the “M-word,” in this public forum, and will allow exhibit 1 speak for itself.

Exhibit 1: Current and Projected Wide-Body Engine Deliveries

We just got back to the US from a trip to Europe, where we met with many insiders, former insiders and others close to Leonardo. In our research update note that we published today, we profile the likely successors to CEO Mauro Moretti, along with the very significant operating performance all of its units have been posting recently. The backlog has started to grow, and we believe a well-picked successor to Moretti will be able to solidly build on this consistently growing backlog now that Moretti has restored the group’s profit margins to levels above his typical European peer and in line with his more respected US peers. There’s absolutely no reason shares of Leonardo trade at a 37-67% discount to its international peers. Yet this discount provides a solid margin of safety for any incremental headwinds that could emerge.

Exhibit 2: Mauro Moretti’s Solid Margin Expansion Record

Lastly, late last year we updated our notes on Flybe in conjunction with buying more shares (we also purchased more this week). Now that a new CEO is coming in to focus on expanding the profitability on existing routes (rather than continuing to grow the company’s capacity), the large majority of its routes that are breakeven should continue to mature to becoming solidly profitable routes. Flybe doesn’t have direct competition on 90% of its routes, so it’s less susceptible to the pricing pressures that without fail re-emerge time after time. Because Buffett has finally changed his view on the airline industry doesn’t mean the barriers to entry have actually increased. We suggest any stock pickers looking for airlines should look at unique niches in the industry where some airlines consistently have earned >30% returns on capital. Flybe is our favorite of this mix. The trading update the company provided a couple weeks ago confirm that the company is well on track to improve the profitability of the routes that it has launched in the last two years – almost all of which were breakeven last year.

You can access the Leonardo, Rolls-Royce, and Flybe updates by clicking the links provided.

Have a great weekend!

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This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

Past performance is no guarantee of future results.

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