Shares in Rolls-Royce have become one of the most high-profile underperformers of recent years. However, despite the share price now sitting some 50% below its all-time high I’m still not tempted to buy.
There are two main reasons:
- The company has a pension scheme which I think is dangerously large
- The share price just isn’t low enough
If those two issues were somehow fixed I would be more than happy to invest because, by most other measures, Rolls-Royce appears to be a solid (but not infallible) company.
A successful company but not quite as defensive as investors thought
There are a few important features that I want any potential investment to have, such as a long history of dividend payments, consistent profits, inflation-beating growth, good profitability and low levels of debt.
Historically Rolls-Royce has more or less hit all of these targets, although problems in 2014 and 2015 have tarnished its record somewhat, as you can see in the chart below.
Although the company’s earnings have been slightly lumpy, the general picture is one of steady and fairly rapid growth. In fact, before the less-than-stellar results of 2015, the company’s growth rate had averaged around 9% per year.
However, that figure has come down as a consequence of a collapse in profits and a 50% cut in the latest final dividend.
A few years ago the idea of Rolls-Royce cutting its dividend was unthinkable, but thanks to an economic slowdown in some of its most important markets, an ongoing transition from old engine models to new models, and a relatively expensive cost-base, management has decided that a dividend cut is in the best interests of the company’s long-term future.
My key financial metrics for Rolls-Royce are as follows (compared to the FTSE 100):
- 10-Year growth rate = 5.1% (FTSE 100 = 2%)
- 10-Year growth quality (i.e. consistency) = 75% (FTSE 100 = 50%)
- 10-Year profitability = 8.3% (FTSE 100 estimated at 10%)
If you’re not familiar with those metrics then have a look at these investment strategy articles.
Overall then, Rolls-Royce has a better financial track record than the average large-cap company (i.e. the FTSE 100), but not spectacularly so. But as 2015 has shown, the company is a long way from being an unstoppable engine of growth and it does operate in a cyclical industry.
So that’s the (relatively) good news, let’s have a look at the bad news.
An extremely large pension scheme makes Rolls-Royce a riskier investment
As I mentioned at the beginning, Rolls-Royce’s pension scheme is one of the two main reasons why I don’t own the company.
I am wary of large pension schemes because they can more easily lead to large pension deficits, which companies are then legally obliged to reduce.
Whether or not Rolls-Royce’s pension scheme has a deficit today is not especially important, in my opinion. What matters is the size of the pension scheme’s liabilities and therefore the potential size of the deficit in future.
There is no magically correct maximum size for a pension scheme, but currently, I use the following rule of thumb:
- Only invest in a company if its pension liabilities are less than ten-times its five-year average profit after tax
This is a ballpark figure which implies that a 10% deficit (a fairly typical figure) would result in a deficit equal in size to the company’s recent average profits.
My assumption is that a deficit of that size would result in a significant portion of the company’s cash flows being directed into the pension scheme, rather than into productive areas within the company or to shareholders as a dividend.
In Rolls-Royce’s case, its five-year average profits are £0.9 billion while its pension liabilities are more than £12 billion. The resulting pension ratio is clearly above 10 and so according to that measure, Rolls-Royce’s pension scheme represents a significant risk to the company’s future prospects.
In addition, pension scheme liabilities have a nasty habit of going up every year. In fact, Rolls-Royce’s pension liabilities have increased from around £7.5 billion in 2009 to that £12 billion figure today. As they continue to go up so do the associated risks.
The share price has collapsed, but not enough to make me want to invest
Rolls-Royce’s share price peaked in late 2013 at almost 1,300p and yet today they stand about 50% lower at 670p.
That’s a pretty unpleasant decline to sit through and it reflects the degree of optimism embedded in the price a few years ago.
Investors thought the company would generate steadily growing cash flows forever, driven by its long service contracts. While those investors may be right in the long term they were definitely wrong in the short term.
At that peak price the company’s dividend yield was as low as 1.8%, so investors would have needed the company to keep growing by at least 8% each year in order to achieve the sort of 10% annual return that I’m after.
Today Rolls-Royce’s share price is much lower, but I’m still not convinced it’s low enough.
Let’s say we’re super-optimistic and that Rolls-Royce can return its dividend back to the 23.1p it reached before being cut.
At today’s price of 670p, a 23.1p dividend would still only give a dividend yield of 3.4%.
While 3.4% is a lot more attractive than a 1.8% yield, it’s below the FTSE 100’s yield of more than 4% and would require (in theory) Rolls-Royce to grow its dividend by at least 6.4% each year to generate a 10% annual return for shareholders.
That may be possible, but as recent events have shown, even mid-single-digit growth rates are hard to come by these days.
According to my stock screen, Rolls-Royce is worth about a fiver
If 670p is too much, what price would I pay?
I’ve given the game away with the heading above, but I’ll say it again for effect:
My current purchase price for Rolls-Royce is 500p.
Why 500p? The main reason is that at 500p the company would be one of the top-ranked stocks on my stock screen, rather than in the unexceptional 145th place out of 240, which is where it currently sits.
More simplistically, if we’re super-optimistic once again and assume that the dividend quickly regains its previous 23.1p peak, then a 500p share price would produce a dividend yield of 4.6%.
That’s the sort of yield I’m typically looking for. In this case, it would mean Rolls-Royce does not have to grow exceptionally (unrealistically?) fast, after the initial recovery from its current problems, in order to generate a 10% annualised return.
Having said that, I still wouldn’t invest at 500p because of the large pension scheme.
But if the company did manage to come up with some way of massively reducing that financial liability then I would be happy to join the army of Rolls-Royce shareholders, but only at 500p or less.
John, fair summary — you’ll never buy it I guess because they will most likely never resolve the pension problem, especially if negative interest rates take hold.
I bought at just over a fiver and sold at 720.
Will buy it back at a fiver again – but to be honest I’m talking on a scale of 1/2 to 1% of my stock portfolio, so it’s hardly going to shoot the lights out.
I think you might be better to focus some energy on Shire Pharmaceuticals in the next months.
Something else I thought about. You are probably getting bored by now because you have eyeballed all the stocks in the FTSE100 and 250 for a good few years.
Maybe you could add another dimension to it and your good following. How about a seperate section that tracks a small selection of AIM stocks?
LR
Hi LR, I think you’re right. RR will probably be off my shopping list for quite a few years.
As for AIM stocks, they’re typically well outside of my risk tolerance zone, and I’m definitely not bored looking at FTSE 100/250 stocks. Perhaps one day I’ll get bored with defensive/dividend stocks and want to look for some “exciting” stocks, but that day has not come yet.
John — Two comments in one day — what, am I bored or something?
This article compounds your pension fears :-
http://www.ft.com/intl/cms/s/0/cc7af80e-eada-11e5-888e-2eadd5fbc4a4.html#axzz43nIEfwsow
If not subscribed, here is a small extract :-
” UK and US companies are weighed down by $520bn in pension deficits and need to “get out of the insurance business”, according to a new report from Citigroup.
The bank’s analysts argue that groups should find ways to close their gaps and then pass their obligations on to the insurance industry.”
Precisely the reason I sold out of all insurance companies and particularly Legal and General who are actively piling up their balance sheet with offloaded pension schemes. Excellent for the management’s short term bonuses, but guaranteed to wreck shareholder value some period down the line.
LR
RR did a “longevity swap” a few years ago covering £3bn of their pension scheme, but that’s only £3bn out of £12bn, and of course dumping pension risk onto someone else comes at a cost. The insurance company isn’t going to take on that risk for fun, so there’s an insurance premium and also the risk that if the average pensioner lifespan turns out to be shorter than expected, RR has to pay the insurer an additional fee.
Hi John, Shouldn’t it be that if the average pensioner lifespan turns out to be “longer”, not shorter, then RR has to pay an additional fee?
If it’s shorter L&G’s liability will be less as they will stop paying out on the pension. Also it seems hard to come to that conclusion at any time in the near future — measuring an average will only be done some 20 years after the contracts were signed.
My biggest worry is that L&G get paid a chunk for taking on the risk and they pile this onto the short term bottom line, flattering the short term profits, boosting the EPS for the management pay packets and in the process building up a huge long term liability.
By the time the true effects of these liabilities are realised, said management will have retired to Marbella, taking up residence in Ronnie Bigg’s old Villa, no?
LR
There’s an article on it in The Actuary here.
Basically it removes uncertainty for RR. The RR pension scheme runs as normal, but:
a) if pensioners live longer than expected the scheme’s liabilities will grow, and so the insurance company (or Deutsche Bank in this case) pay into the scheme to either top up its assets or directly pay the pension outflows (I have no idea which).
or
b) if pensioner’s lives are shorter than expected then the pension scheme will benefit as its liabilities will be reduced, but in that case RR must pay out the difference between expected and actual cash flows to Deutsche Bank.
So RR’s pension fund cash flows are known and effectively hedged. It’s like an interest rate swap or other hedging mechanism for fuel costs or whatever, not that I’m an expert in such matters by any stretch of the imagination.
As for L&G, you could well be right to worry. Pensioners have long had a habit of living longer than expected. Perhaps Soylent Green is the answer.
“It’s like an interest rate swap or other hedging mechanism for fuel costs or whatever”
Another reason to worry. Have you seen “The Big Short”. Entertaining film, but sobering considering it’s based true events and highlights the fraudulence of the major world financial operators.
What’s happening with the offloading (or parcel passing) of pension liabilities is no different.
There is a warning at the end of the film regarding “Bespoke Tranche Opportunities” which is a new name for a CDO (Collateral Debt Obligation” — the very vehicle that blew up the financial system in 2008.
Yes I’ve seen The Big Short, it’s a good attempt at a “fin-com” (financial comedy, which doesn’t exactly sound like a winning genre).
I agree that the risks associated with large pension funds don’t disappear just because they’re offloaded to an insurer. Whether or not there’s a subsequent crisis depends on the total amount of risk across the system, the correlation of those risks and whether they’re underpriced.
With the sub-prime crisis we had all of those: Too much risk, too closely correlated and massively underpriced because it was labelled triple-A when in fact it was junk.
The same sort of thing occurred in the Lloyd’s insurance market in the 1980s when everyone started passing risks off to someone else and taking a fixed fee.
Whether or not this offloading of pension fund risk can cause a wider crisis, or even just problems for the insurers, I cannot say. But that’s certainly one reason why I always spread my portfolio across a wide array of unconnected industries.
John,
One reason Rolls- Royce shares could become appealing is if they were to be subject to a takeover?
Given its defence risk, say to companies like BAE, it would be in the interest of a big British defence company not to let Rolls-Royce go to a foreign buyer.
At around £5 or sub £5,and combined with its current pension liabilities, this share sits on a high risk of being subject to a buyout.
AH
Hi Andy, yes I’d agree with that; a hostile takeover is a real possibility, or even as you suggest a defensive takeover to avoid RR going overseas.
This is the share I got it wrong. I made money with RR but I could have made more, a lot more, if I sold after the first profit warning as I usually do. Instead of this I double it up, now I learned that although it worked well in the past for me, this is a rocky error. It costed me 1.5% performance for last year on my portfolio.
In the end the stop loss at 750 saved my skin. I would have bought again around 550, but I have taken as clients a few UK and US managers and I did get to know a few things, not classed an inside trader, but after checking with a compliance consultant I decide not to be involved in RR.
RR has got its market wrong. RR expected that orders for 500+ seats (wide body) airplanes will skyrocket but it did not happen. It has the best airplane engine in the world which fits the airplane which does not sell in great numbers.
For a moment RR took its eyes of the short and mid range airplanes (A320 and B737) and it was enough for its competitors to replace it.
What follows now is a cost reduction exercise and many of my clients are waiting for redundancy payments. It will take a while for RR to recover.
I thought it will be good to say something about L&G. I am not an actuary at L&G, but I know that a life insurer has a lot of insight into the life expectancy issue, a lot higher than a pension administrator like Mercer or Towers Wattson etc.
An insurer also has the opportunity to hedge itself. For example as a financial planner I arrange a fair amount of Whole of life (WOL) assurance policies, mainly to cover IHT liabilities. If the RR pensioners leave longer, it may be that also holders of WOL policies will do an pay life insurance premiums for longer than the insurer expects. It is true that you need around 5 people paying life assurance premiums to hedge one RR retiree, but it works to some extent.
Many insurance companies reinsurer themselves and one of the firms offering counteparty is Warren Buffet’s Berkshire Hathaway’s reinsurers. His reinsurance companies love buying long term liabilities and getting paid a premium upfront. He bought the asbestos liabilities from Lloyds syndicates and now buys a lot of life expectancy liabilities.
In the end it builds the firm insurance’s float. Should Warren be good at getting a 10% per annum investment return on the float, everyone will be happy. Should that not happen, pension schemes like RR may find themselves having a counteparty that’s gone bust and back to square one.
Some interesting points there Eugen. On the wider pension deficit issue, I haven’t looked at it in detail so I don’t know if it’s a disaster in the making, but I know enough to know that it’s a problem at the individual company level, which is why I’m keen to avoid these liabilities in the first place.
I hold BAE which has a massive pension, but I bought that years ago before adding in these rules. The BAE pension isn’t a problem (yet) so while the big pension is a risk it isn’t enough to make me want to sell.
Pension liabilities are one of the many things that need considering when investing in a company. These are long term liabilities, the advantage is that when these increase the company makes a plan to make the deficit good over the next 10 years. It is not something that a company needs to make good immediately.
It is nevertheless a cost that the company needs to pay it each year.
Obviously firms that have been for longer around and high intensive with lots of workers well paid have built higher pension scheme than other companies. BAE, RR, Shell, BP have high pension schemes. Some they have US unfunded benefits like healthcare etc. Few know that Shell has a Bermudian based defined benefit for its foreign workers, half the value of the U.K. pension scheme. It seems however that Shell’s pension schemes are well funded.
It is interesting what you say about BAE. It seems that you would not buy BAE again, but you are happy to hold it. Is this a behavioral bias?
I work with clients and I need to treat them fairly and I can’t think like this. I do not have a “hold” option on my buying list. If I keep a fund or an allocation to an asset for a client, it is because I will buy it for the client that comes through the door tomorrow. That means that it has an expected investment return and has a function in terms of correlation in the client portfolio.
Otherwise it cannot be in the portfolio only because it is a “hold”.
It is the same with anchoring on the price I bought a stock or a fund. The market does not know the price I bought into it. The decision to sell should be made without looking at the price it was purchased.
I know it is hard, so I have decided to rely on stop loss orders long time ago, so I am not anchored. Using stop loses is a bit like a momentum play, the stock which lost its momentum gets sold automatically.
” Is this a behavioral bias?”
I don’t think it is, although it might be. I think of each stock as being on a spectrum between once-in-a-lifetime buying opportunity, through to something I’m happy to hold but not to buy any more of, and finally onto once-in-a-lifetime shorting opportunity (not that I ever go short).
BAE is somewhere in the middle right now, and especially so given its pension, so yes I’m happy to keep holding but wouldn’t buy any more, and I don’t think there’s a contradiction in that statement (at least not an obvious one).
One last thing about RR. When I sold the shares I thought that I should invest the proceeds into another engineering firm, although at that time I had another compelling investment story Lloyds Bank.
It took me a while to find one so I invested about 45% of the proceeds in Lloyds Bank shares and that did turn out quite good, although I have higher expectation in the future for this bank (which may not happen).
So I choose Tesla in the end, although many people were shorting the stock at that time, claiming the stock was too expensive. Yesterday there was a great day for Tesla with 138,000 pre-orders taken in one day for Model 3. At $1,000 deposit this gave Tesla $138 million, enough to build a new factory which is bloody needed now to deliver the cars.
I intend to keep this very high risk bet and not too halve and take profits it as I ussualy do. It is only 2.5% of my portfolio in the end.
Tesla is certainly a disruptive company and probably in 10 years there will not be any petrol and diesel cars for sale apart for a few petrol heads clients.
Let’s be clear, a lot could go wrong from here. Taking high number of orders is one thing, delivering the cars is another bloody hard job. The car may be prone to faults etc.
BMW is moving quickly in this market and others will follow. I have BMW shares as well and even a few VW shares bought very cheap after the scandal erupted.
Tesla is certainly an interesting company and with the new Model 3 you can see how they’re moving towards their interpretation of tomorrow’s car, i.e. it is not trying to emulate “normal” cars as much as the Model S and X. Personally I’m a Toyota fan so I’m waiting for an affordable hydrogen car.
I will not drive s Hydrogen fuelled car, it is like you drive a bomb already armed. Put that in an aluminium body of a car and you did not get even the time to get out of it.
So just like a petrol car then?
Tesla is indeed an interesting company and you wouldn’t want to bet against Elon Musk. He took orders for 194,000 model 3’s in 24 hours. That’s more than all the electric cars sold in the US to date.
This is going to fly and it’s making me think seriously about my historically successful investment in Johnson Matthey.
Hi LR, I’d agree that Tesla is probably going to be able to scale up considerably from where it is, but whether or not it’s a good investment depends on whether that’s already in the price (as you already know). The current market cap is over $30 billion so it will have to generate billions in profit every year before that valuation starts to look sensible. At an optimistic profit margin of 10% that requires tens of billions per year of revenues. I’m a Tesla fan but there’s a long way to go before they hit that point.