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Rolls Royce (RR/ LN): Mind the Gap

In the past month, we have built a new core position in Rolls Royce (RR/ LN). We have been uncharacteristically quiet as it relates to our latest core large-cap position, because we’ve been trying to influence the focus of the new CEO (who has an excellent track record) on operational issues. We’ve also been trying to build a groundswell of support for our operational plan amongst some large suggestivist investors – although not ValueAct oddly enough, as Ubben is one of our role models. Now that the horse is leaving the barn on the Rolls opportunity, and an earlier copy of our research has been posted elsewhere, we’re pleased to publicly post the research that we shared with investors earlier in the month.

Rolls is going through a perfect storm right now. It is rapidly growing its large engine installed base (it has the most fuel efficient large engines in the world), and it’s selling these engines at a loss. While Jeff Bezos would love this long-term investment prospect, nearly everyone else in the western world has run away. Only 18% of sell-side analysts still recommend buying shares of the company, and confusion is running very high – consensus operating income estimates for next year are for anywhere from £1 billion to £2 billion. You could fly an A350 through that spread, it’s so wide. Actually, if we stacked up the coins of one billion quid, the distance would be able to accommodate over 45,000 A350s simultaneously.

In our first research piece (with assuredly, many more to come), we have sought to engage in a discussion about the one factor that will make the biggest difference in our investment returns in Rolls Royce: the deep margin gap its civil aerospace division has relative to GE. While a cyclical recovery in capital spending in the land & sea division (we’re not counting on it), could drive a fair amount of incremental upside (perhaps £1.00-2.00), it pales in comparison to the significant opportunity the company has if it were to emulate its American competitor and fix the margins on its engine sales. The financial metrics presented herein are a bullish scenario if the company were to enact the operational initiatives described. Until the company starts taking action, they will most certainly be wrong, and be too optimistic. Furthermore, we have continued to refine our model assumptions since this report was published, and will be publishing an updated set of financials in our next post. Our point was to show the significant difference that can be made if the new CEO uses his engineering background to fix the inefficiencies that lie in the supply chain. Thankfully, on his daily commute to work, he’ll be reminded to, “Mind the Gap.”

Please click here to access our 25-page report from July 9.

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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.

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