Everything seems to be going well for Rolls-Royce.
So well, in fact, that, as you may have seen, the company recently had a royal visit to a factory in Singapore where another exceptional engine was unveiled to the world.
However, although Rolls-Royce has done exceedingly well in the last decade, Rolls-Royce shares have done even better.
In the last decade, turnover has gone from £5.8 billion to £11.1 billion; profits have gone from around £200 million to over the £1 billion mark, and dividends have gone from 8p per share to more than 17p.
Overall the company’s growth rate has been upwards of 10% a year, an exceptional figure for a FTSE 100 listed company whose market value is more than £15 billion.
You can see the results of this outstanding decade below:
You’ll have to ignore the manic earnings swing of 2008/9, which was currency-related and didn’t show up in the adjusted, underlying EPS figures. The turnover and dividends show the underlying picture of steady growth much better.
In the last decade, the company has roughly doubled its ability to generate sales, profits and cash dividends for investors; but that is literally nothing when compared to the returns from Rolls-Royce shares.
Unbelievable shareholder gains
In 2002 you could have picked them up for less than 200p each. If you were a really serious bargain hunter, then you may have loaded up with Rolls-Royce shares at the incredible price of 69p in March 2003.
Since then, the shares have risen to more than 800p, almost touching 900p a few weeks ago. That’s a gain of more than 300% in the last decade, even without taking dividend income into account.
If you had bought the shares for less than 80p at almost any time during March 2003 and then sold at more than 800p at any time since March this year, then you would have found the mystical “10-bagger” and generated over 900% profit in only nine years.
The more they rise, the further they have to fall?
I wrote about the bubble in defensive stocks recently, and I think that Rolls-Royce shares may be a prime example of this particular bubble.
The underlying company is definitely defensive. It’s large, global, robust, diversified and carries little debt. It’s a great global success story with a consistent ability to grow year after year.
So don’t be in any doubt – I think that Rolls-Royce is a great defensive company and one that I would be happy to invest in at the right price. But are Rolls-Royce shares worth more than 800 pence each?
At today’s price of 830p, each share has a dividend yield of just 2.1%. I can get 3.7% (a 76% improvement in income) from the safety of a FTSE 100 index tracker. The current normalised PE is 18.8, also well above the market’s PE of 11.4.
Looking at the ‘cyclically adjusted’ PE using average earnings over a 10-year business ‘cycle’, I can see another indicator of an overvalued share. Rolls-Royce shares are priced at around 30 times their cyclically adjusted earnings, while the FTSE 100 is less than half that at under 15 times.
Of course, if Rolls-Royce continues to grow while steadily increasing its dividend and if investors continue to give the company a lofty valuation, then the shares may still do well in the future.
But let’s look at it another way. The last time the FTSE 100 was valued as highly as Rolls-Royce is today (at 30 times its cyclically adjusted earnings) was 1999. Investors had invested in a great asset, namely the UK equity market. It had grown earnings and dividends consistently well for years, and the FTSE 100 had gone from around 2,000 in 1990 to almost 7,000 in 1999.
In essence, the price of the market had risen far faster than its underlying value.
So what happened next? The value of the market collapsed by about 50%, and we are still not above 7,000 today, more than 12 years later.
I’m not saying that this fate awaits Rolls-Royce shareholders. But let’s say the shares fell by 50% tomorrow, back to just over 400p.
Just imagine that some bad news came out that was bad enough to trigger such a fall and yet not really affect the long-term prospects of the company (although the market would think otherwise, extrapolating today’s bad news further into the future than it really deserves).
At 400p, what would we have?
We’d have a big, international, relatively defensive company that can consistently grow at around 10% a year. It would have a yield of perhaps 4.2%, a PE of around 9.4 and a cyclically adjusted PE of about 15.
Surely investors wouldn’t allow such a fantastic business to trade at such a low PE with such an attractive yield?
Well, let’s look at Tesco.
It’s a big, international, relatively defensive company with a history of consistently growing at more than 10% a year. It has a yield of 4.3%, a PE of 10.5 and a cyclically adjusted PE of 14.5. Almost exactly the same as Rolls-Royce shares would have if the price fell to 400p today.
The bad news for Rolls-Royce shareholders is that Tesco really is that cheap, and there’s no fundamental reason why Rolls-Royce shares can’t fall back to 400p either.
That may sound crazy, but it’s where they were just three short years ago, and they could easily go back there in the next three years.
Tesco and Rolls Royce are not the same thing. One sells sugar, the other sells aircraft engines. The first is on a small margin, the second has a huge margin.
Engines are sold now with servicing (renewal income) which makes the company more profitable. In the next 20 years the expectancy is for 68,000 aircraft deliveries. Only the engines for these are worth $3.4trn. There are only three producers in the word so let’s say that RR will have a fair share of $1trn.
I could go even further: 10% profit is $100bln so at £16bln market cap the company is rather cheap.
Hi Eugen, well let’s hope for RR shareholders that you’re right!
I realise that Tesco and RR are quite different businesses, but in terms of cash return to shareholders they are quite similar. They both pay a progressive dividend with perhaps a better than average chance of continuing that trend for many years to come.
I tend to look at businesses as black boxes, whereas I know that you like to dig into their innards, so I’m not surprised that we end up with different opinions, which is good because variety adds a bit of spice to life.
John
I doubt Tesco could carry on paying a progressive dividend. I don’t like forecasting earnings but I have a feeling they are going to come short again. Obviously time for Warren to buy a few more shares.
John
So far it worked for me. From 1st of October: Tesco up 16.50%, RR up 23% and FTSE up 12.9%.
The good thing about RR is that the cashflow is positive now, probably time for some free cash flow given back to shareholders or reinvested in the business if there are oportunities. The company is at the end of a big investment cycle which resulted in very new engines with reduced consumption that the market dies for to reduce cost.
Still lots to be seen from this company, hopefully the managers are up to the job and stop investing in the low profit part of the business.
Hi Eugen, well good luck with RR! Let me know how things work out when you eventually sell.
Sweet day for me today. RR broke the 1,100 support, but big news from another holding of mine, the old boy – Boeing. I only hold it to hedge myself on RR, but Ryanair made us rich today with a big order to Boeing using RR engines. I have a feeling I may double my money on Boeing (again) as a few more orders are expected.
I have told you that we are on a $3.4 trn market for the next 20 years with a 10% margin. And this is only for engines, but there are lots of other things needed, fuel pumps, measurement equipment etc.
I started investing in this industry when I was working in an enginering company 6 years ago, machining the support that holds the passenger seats in the A 320 as I wasn’t been able to keep up with the demand. I was doing two planes a week (624 supports) between 6 workers (75 hours a week and £1,000/week, not bad money for an East European engineer, like me) and orders were increasing every day.
In my first days working for them I was amazed they don’t send this work to China and no need to pay me £14 per hour, only to learn that apart from a bit of a security issues, China can’t offer the quality required even for passenger seat supports. After that, working on supports for RR engines (promoted), I found that I won’t fly a plane with chinese engines, as these may fall out of the sky more often.
I like this oligopoly (shall I name it competitive advantage) and also the 10% margin on turnover. investment needs to be simple, and a bit of luck is also needed. Myself, in investments I was bloody lucky, I need to be careful now when I pass on the other side of the street.
Hi Eugen, looks like you really know this industry. However, if it was me holding RR I’d be selling now as the shares have had a great run up, valuations are stretching, and just like an elastic band, the more you stretch valuations, the more they want to go back the other way, regardless of what the underlying company does. However, I wish you luck with it, whatever happens.
John
It depends how you value this company. The stock grew yesterday for a reason, there was a new order priced in and the investors discounted the perceived free cash flow from that order. The company as it was on Monday is diferrent from the company on Tuesday when it pocketed a new order so the stock price should be different.
if Balfour Beatty wins a contract tomorrow in Romania to build a motorway for €4 bln you will ask 10% more for your shares. Today we had a 5% increase in the share prices for a few builders only on the news from the budget.
John, I believe there are a few issues with your way to value companies. Your methods may work well when the interest rates will normalize (go back to 3.5%-4%) but on an interest rate of 0.5% per annum valuations are pushed higher.
In my opinion, we are very, very far from normalised interest rates. Or it may result that 0.5% per annum becomes the new normal. Speaking with a very young broker from Japan the other day he said to me that 0.25% per annum is their normal interest rate.
What I like at a company like RR is that you could work backwards knowing the order book and the average margin to calculate the discounting rate and the cost of capital.
I do have a stop loss order for 1050p.
I guess we will have to wait and see. Let’s come back in 5 years and then we’ll have a better idea of whether 1,100p in March 2013 was a good price or not.