VOLSUNG MANAGEMENT - Rolls Royce Holdings plc (LSE:RR)
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VOLSUNG MANAGEMENT – Rolls Royce Holdings plc (LSE:RR)
June 12, 2014 – SumZero FactSet Non-US Idea Contest Submission
Investment Thesis:
Oligopoly aircraft engine manufacturer with insurmountable near-term barriers to entry and high-visibility,
recurring revenues thanks to almost total capture of aftermarket opportunity. Ramp-up of Trent
1000/XWB program will lead to surging revenues and potentially double margins as RR enters the lower
risk ‘sweet spot’ of a multi-decade product cycle. In-place product platforms offer 10+ years of high
visibility, high margin growth driven by a near 2xing of the installed engine base.
Business Summary:
Rolls Royce Holdings plc (LSE:RR) is one of the world’s leading manufacturers of complex, highly
engineered engines for aerospace, marine, and energy applications. Our investment thesis hinges on the
company’s civil aerospace business, which manufactures and services engines primarily for large
widebody commercial aircraft.
RR is significantly expanding its share of the widebody engine market thanks to the successful platform
wins of its newest series of engines, which will likely make the company the market leader in this segment
as it delivers on its current order book. RR’s benefits from stable, predictable economics, with almost ½
of 2013 revenues coming from long-term annuity-like service revenues earned on the existing installed
base of engines with useful lives exceeding 25 years. RR is in the final stages of the significant
investment spending program which will enable a surge in engine production starting in late 2014,
generating decades of high-margin, recurring revenues, even as this expense ramp temporarily
depresses current operating results. We believe this creates a highly compelling asymmetrical risk/reward
proposition and an attractive investment opportunity.
Despite the high quality of the business and its secure competitive moat, we believe that RR shares are
historically cheap for several reasons. Analysts are concerned by the degree of the contraction in the
company’s defense business in 2015 and are skeptical over management’s long-term guidance for the
segment. Defense concerns are magnified by management’s conservative guidance for the marine
business, which is coming down from a period of explosive growth in recent years. Finally, elevated costs
in advance of the deliveries of a new generation of engines create uncertainty as to the eventual
profitability of these engines, while a dearth of new orders has been created by the significant existing
backlog and delays by airframe OEMs in delivering the next generation of widebody. We believe that
these are transient factors which give little credit for the inherently defensive quality of the business, and
which unduly extrapolate short-term concerns against a business with a history of delivering on long-term
growth and value creation.
Rolls Royce Civil Aerospace – From Widebody Obscurity to Market Leader:
RR’s civil aerospace business manufactures large engines for widebody aircraft as well as smaller
engines primarily for corporate and regional jets. Despite being a distant third in the widebody engine
market as recently as 20 years ago, RR is today poised to become the market share leader in widebody
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aircraft engines and we believe the company is enjoying the strongest competitive position in its history.
We will briefly recap the company’s operating history in civil aerospace before discussing the economics
of the civil aerospace engine business and the company’s current product portfolio.
Rolls Royce was a pioneering giant of the reciprocating piston engine era, powering a significant portion of
the allied air effort in World War I and II, including designing the legendary Merlin engine which powered
the most successful variants of the Supermarine Spitfire and the P-51 Mustang. RR continued to develop
a significant portfolio of successful turboprop and jet engines for military aircraft in the post-war years but
was slow to enter the emerging civilian aerospace market. After missing out on the groundbreaking Boeing
747 and McDonnell Douglas DC-10, which were initially powered by General Electric and Pratt & Whitney
engines, RR belatedly responded in the ‘60s by winning an exclusive contract to provide the launch engine
for Lockheed’s proposed widebody competitor, the L-1011.
RR’s RB211 engine which was to power the L-1011, however, seemed to be an almost unmitigated disaster
at the time, suffering numerous delays and initial reliability problems. The cost overruns and delays
associated with engine’s initial development almost bankrupted the company, leading then Prime Minister
Ted Heath to nationalize RR in 1971. RR’s initial failures with the RB211 jeopardized the entire L-1011
program and were a decisive factor in Lockheed’s decision to abandon commercial aircraft production
altogether.
Despite its development problems and the damage done to RR’s credibility with customers and partners
by the RB211-L1011 fiasco, subsequent iterations of the RB211 would prove to be highly successful
engines. The reliable and cost-efficient RB211 would transform RR into a top-tier global competitor in
civil aerospace, and variants of the RB211 would win a meaningful share of orders as an alternative
offering on the Boeing 747-200 and 747-400, as well as on the later Boeing 757 and 767. The RB211-
524 variant in particular was to be a milestone for the company, becoming the first RR engine to be
selected by Boeing as a launch engine for the 757, first delivered to customers in 1983. The success of
the RB211-524 on the 757 led to the first major orders for RR-powered aircraft from an American airline
since the early days of the Lockheed L-1011.
While the RB211 returned RR to commercial significance, its widebody market share was still just 8% at
the time of its privatization by Margaret Thatcher in 1987, making the company a distant third to GE and
Pratt & Whitney, and questions remained over the company’s ability to continue to compete on future
aircraft platforms. However, having already achieved a foothold for RR in the widebody engine market,
the reliable RB211 would provide the foundation for its eventual successor, the Trent engine, which would
cement the company’s position in widebody engines and lead the company to new heights.
Development of the Trent series of engines was formally announced in 1988, with RR stating its intention
to use the versatile three-spool design of the RB211, which remained a departure from the two-spool
designs favored by GE and Pratt & Whitney. The three-spool design adds additional engineering
complexity, but allows each engine module to be more readily tailored to meet a range of performance
and thrust targets depending on the specific needs of airframe manufacturers, as well as offering potential
weight savings. Despite initial commercial setbacks with the aborted Trent 600, the subsequent Trent 700
iteration became the first RR engine to power an Airbus aircraft, becoming the launch engine for the A330
in 1990. The Trent 700 was to be the first major widebody success for RR, winning 57% market share on
the highly successful A330, and remains in production today.
The success of the Trent series continued in the later years of the ‘90s with the Trent 800, designed for
the Boeing 777 and entering service in 1996, which won more than 40% market share against
competitive offerings from GE and P&W. Despite failing to win a place on Boeing’s long-range 777 (due
to GE’s willingness to subsidize the aircraft’s development in order to win exclusivity), the Trent 500 would
win exclusive positions on the competing Airbus A340-500 and -600 variants in 1997, being chosen over
a competing offering from Pratt & Whitney. These successes followed on the announcement in 1996 that
RR’s Trent 900 would power the gigantic Airbus A380.
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£70,000
£60,000
£50,000
£40,000
£30,000
£20,000
£10,000
£-
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
RR’s surging order book in the late ‘00s has primarily been driven by the 787 & A350XWB
To date, RR claims that Trent engine has won some 40% market share on the platforms on which it
competes since its introduction. The successes of the ‘90s helped RR build lasting relationships with key
airline customers and made the company a legitimate contender in the wide body market, setting the
stage for the current generation of platform wins. Today, RR has won a place on 3 of the key widebody
aircraft offerings: the Boeing 787, the Airbus A380, and the Airbus A350XWB. With an exclusive position
on the A350XWB, the #2 position on the 787 program, and a modest market share lead for GE on the
A380, RR is poised to take a market share lead in the widebody engine market as production of these
platforms begins to ramp up in the coming years. RR will now have the scale and reach in the widebody
engine market it has heretofore lacked, and we believe the long-lasting impact of these successes will
bring about a step-change in the company’s financial performance over the next decade and beyond.
Jet Engine Economics, Customer Criteria, and the Revenue Lifecycle:
Jet engines generally have working lives exceeding 20 years and the development cycle for engines can
span more than a decade, comprising billions of dollars and millions of man-hours of development,
design, testing, and certification work. While this lengthy development process for new platforms involves
significant engineering risk and uncertainty as to whether an engine will ultimately be selected by the
airframe manufacturer, the relationship between engine and airframe manufacturers demands close
cooperation and is generally constructive. Furthermore, once an engine has been selected by one of the
two dominant airframe manufacturers and achieved final regulatory certification, the rewards are
significant and lasting. We believe that RR is currently at an attractive point in the cycle where it is poised
to benefit from the latest generation of widebody platform wins, having already incurred much of the
expenses necessary to deliver these engines, while the next round of major widebody bidding
opportunities is likely to be a decade or more away.
The long working lives of jet engines and the long development period creates a predictable, long-tailed
revenue cycle, with a single engine platform generally driving new equipment sales for 10+ years, and
then providing 20+ years of maintenance, repair, & overhaul (MRO) revenues. This is because jet
engines are generally sold on a ‘razor and blade’ basis, with manufacturers selling engines at a significant
discount to their list price (in some cases 80% or more) as long as the engine is sold bundled with lifetime
service agreements (LTSAs) and spare parts contracts, which are generally worth 2-3x the sticker price of
the engine. This “power by the hour” model, with revenue earned for every mile flown, allows engine
manufacturers to recover their investment over a period of several decades, lending an unusual degree of
persistency to revenues.
Customers ordering aircraft generally select an engine based on a number of factors. Interviews with
former engine executives suggest that the primary concern of customers is the initial upfront cost of the
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either directly from the airframe or engine manufacturer or from a 3rd party bank or lessor. Maintenance
expenses, as generally encapsulated in “power by the hour” offers (including the prospective rate,
turnaround time guarantees, guarantees on availability of spare engines and parts, and included
warranties) are generally ancillary to the above factors, but play a significant role in decision-making as
they are also a determining factor in the initial upfront cost. Given that the practical differences in all of
the above elements between competing options are generally quite small or mutually offsetting, in
practice this decision can often come down to personal relationships between engine and airline
executives.
Once an airline has committed to an engine, it is very rare for an airline to attempt to shift orders from one
engine manufacturer to another, or to make additional aircraft orders with a different engine partner.
Doing so incurs incremental training costs for maintenance and flight personnel and may also incur
significant legal costs for backing out of previously agreed deals. This means that early order books for
airframes are generally indicative of future volumes and that the initial market share of an engine on an
aircraft platform tends to remain fairly stable over the platform’s life. Furthermore, once installed,
replacing an existing engine is generally regarded as uneconomical, meaning that engines under LTSAs
will generate revenues as long as the aircraft remains in service.
RR’s LTSA offering is branded as ‘TotalCare’ and charges customers a fixed cost per flight hour, with RR
responsible for almost all maintenance costs incurred, although in practice there is some ambiguity as to
what charges exactly are or are not included in power by the hour agreements due to the sheer
complexity of the contractual language. TotalCare is available either as a monthly billable service or
billable on service, with both offerings based on hours flown.
Customers find these LTSAs attractive for a number of reasons. they are able to lock in maintenance
costs up front (generally at a meaningful discount to what 3rd party or in-house MRO would cost) and
there is no possibility of being overbilled for service given the alignment of incentives. Furthermore, with
the majority aircraft opex comprised of engine maintenance, and the significant volatility associated with
customers’ other major line items (such as fuel & labor expense), carriers value the comparative certainty
provided by “power by the hour” service. “Power by the hour” also limits the direct financial losses from
engines plagued with reliability issues, although it obviously does not fully eliminate the possibility of
reduced availability associated with recurring engine maintenance.
Based on estimates from former engine executives, labor and repair revenues under LTSAs offer
comparatively low margins of approximately 5% and 10-20%, respectively, but spare and replacement
parts are highly profitable with margins of some 50-80%. This is largely because LTSAs typically discount
labor and repairs charges, but offer no such discounts for parts, which feature significant mark-ups on
cost. From a cost perspective, materials and parts are probably ¾ of MRO expense, with labor
accounting for the remainder.
TotalCare requires that RR stand behind the quality of its engineering and manufacturing. We are
comfortable with the performance guarantees and contingent risks inherent to TotalCare for several
reasons: RR as a business already lives and dies by its the quality of its engineering work; the current
generation of engines are largely iterative improvements of designs with several million flying hours and
generally not wholly de novo products; and, even absent the explicit guarantees contained in LTSA
agreements, we believe that RR would likely be forced to stand behind any significant engineering and
manufacturing failures above and beyond its warranty guarantees in order to retain its relationships with
airline partners. Essentially, this is a risk already inherent to the business, and RR’s codification of this
risk in its LTSAs provides an attractive selling point for customers without adding much in the way of
actual incremental operational risk. It is the nature of such an engineering intensive business that
success is a function of design and manufacturing quality.
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Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/2019In any case, RR’s reputation for reliability is generally regarded as being best-in-class. Discussions with
engineers and mechanics suggest that RR has traditionally maintained a reputation for being reliability-
oriented in their engineering and has generally offered better performance retention over time than peers,
as well as the best maintenance monitoring program available, resulting in longer time on-wing and lower
lifetime cost of operation for RR engines. This has historically allowed RR to remain competitive against
engines with modestly better long-range fuel efficiency, although as we will further discuss, the respective
attractiveness of one engine over another depends on intended mission and usage, and there is not
necessarily one engine design that is universally better or more efficient than others for all potential
applications.
The insurance-like nature of the TotalCare product also provides ‘float’ to fund the business, as income
accrues ratably even as the bulk of maintenance costs are back-loaded towards the second decade of
operations. This makes the planned ramp-up in deliveries in the coming years especially valuable, as RR
will experience a surge in LTSA billings without a subsequent increase in service expense. Furthermore,
the complex tooling and assembly process associated with launching production of new engines (and
expanding attendant service capabilities) requires significant capital investments. This amplifies the initial
deferral of revenues by the “razor and blade model”, even as this incremental capital expenditure is
wholly success-based and therefore incurs limited risk.
RR is currently in the midst of its largest ever investment of this nature, incurring significant unabsorbed
fixed costs as it expands production facilities to prepare for deliveries of the Trent XWB later this year.
This will amplify the impact of the production ramp-up (with incremental service revenues being earned
without attendant service costs) due to the leverage of a significant amount of unabsorbed fixed costs.
We believe these complications magnify the analytical challenge for sell-side analysts trying to unpack
RR’s currently bloated cost structure, and we believe the consensus is underestimating the degree to
which the Trent 1000/XWB deliveries will radically alter RR’s revenue and margin profile.
TotalCare also introduces significant accounting complexity into RR’s accounts, and has presented some
challenges to the company and its auditors in deciding how to account for these agreements. These
concerns have resulted in a back-and-forth with the UK accounting regulator, with RR agreeing to adjust
certain accruals related to the accounting for entry fees on risk and revenue sharing arrangements with
partners[*]. We are comfortable with the manner in which RR accounts for TotalCare revenues, as we
believe the assumptions faithfully reflect the economics of the agreement and do not allow undue scope
for earnings management.
Current Engine Platforms:
Having addressed the economics of the civil aerospace engine business, we now turn to the company’s
current product portfolio, encompassing both the installed base of legacy programs as well as the core
growth programs which will drive near-term earnings growth. Our assumptions about the persistency of
each of these legacy programs will factor into our subsequent estimates of the value of current installed
base.
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Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
RB211 22B 249 195 165 156 132 120 81 66 42 30 21 12 12 6
RB211 524 1,069 1,058 1,042 1,019 1,003 994 953 944 895 848 783 752 685 626
RB211 535 1,096 1,164 1,196 1,206 1,218 1,214 1,210 1,206 1,204 1,196 1,196 1,172 1,166 1,154
RB211 Total: 2,414 2,417 2,403 2,381 2,353 2,328 2,244 2,216 2,141 2,074 2,000 1,936 1,863 1,786
Trent 500 - 12 48 132 220 300 388 424 456 508 520 524 524 520
Trent 700 134 178 206 235 264 306 364 424 494 608 724 840 980 1,144
Trent 800 224 296 344 376 392 408 432 444 442 450 450 450 450 444
Trent 900 - - - - - - 16 20 36 68 96 152 216 252
Trent 1000 - - - - - - - - - - - 14 52 94
Trent XWB - - - - - - - - - - - - - -
Trent Total: 358 486 598 743 876 1,014 1,200 1,312 1,428 1,634 1,790 1,980 2,222 2,454
Large Engines Total: 2,772 2,903 3,001 3,124 3,229 3,342 3,444 3,528 3,569 3,708 3,790 3,916 4,085 4,240
Spey 1,472 1,442 1,408 1,376 1,342 1,246 1,204 1,158 1,132 1,056 1,000 892 848 768
Tay 1,640 1,714 1,772 1,830 1,847 1,866 1,890 1,903 1,951 2,017 2,057 2,077 2,119 2,155
AE3007 986 1,380 1,718 1,966 2,200 2,370 2,476 2,596 2,710 2,782 2,814 2,850 2,896 2,950
BR700 448 662 792 904 1,006 1,164 1,312 1,480 1,650 1,832 2,032 2,226 2,448 2,744
Small Engines Total: 4,546 5,198 5,690 6,076 6,395 6,646 6,882 7,137 7,443 7,687 7,903 8,045 8,311 8,617
V2500 638 759 872 971 1,080 1,217 1,361 1,496 1,650 1,794 1,949 2,119 - -
Civil Aerospace Total: 7,956 8,860 9,563 10,171 10,704 11,205 11,687 12,161 12,662 13,189 13,642 14,080 12,396 12,857
The widebody large aircraft engine business comprises the legacy RB211 engine family, dating to the
early ‘60s with significant numbers still in service, and the Trent engine family, which was originally
introduced in the early ‘90s and which represents the present and future of the company.
Despite its increasing age, latter variants of the RB211 will likely remain a workhorse platform for a
considerable amount of time to come, with passenger service retirements being partially offset by
conversion of airframes to freighters. The venerable 22-B variant powers the L-1011, of which a handful
remain in service but which are uneconomic to operate today and which will soon be relegated to the
status of museum piece. The 524 variant powers the 747-200 and 747-400, as well as the 767-300, with
many of these aircraft being retired from passenger service or converted into freighters over the past 15
years. We expect the majority of the 524s to be retired by the end of the decade as the 787 enters
service with the key remaining operators of the 767-300, although a handful of -300s operated primarily
by Asian airlines could remain in service well into the 2020s. The most modern version of the RB211, the
RB211-535, powered the 757-200 and -300, of which new deliveries were still being made as recently as
2005, and a significant number of 535s will likely remain in service for a decade or more.
The Trent 500 powers the long-range variants of the Airbus A340, production of which peaked in the mid
‘00s. Despite being a comparatively recent platform, questions remain over the Trent 500’s future. Due
to sustained high oil prices, the four engine configuration of the A340 is no longer as economical to
operate as comparable twin-jet models like the 777 and A330, which have proven capable of operating in
the same role with greater fuel efficiency. With customers retreating from the platform and resale prices
plummeting, the A340 program has proven to be a costly mistake for Airbus. RR is unlikely to generate a
significant return on investment from the in-service Trent 500s, a handful of which have already been
retired after just 10 years of service, speaking to the potential risks to the LTSA model should the
airframe fail to live up to expectations.
The failure of the A340 program has been compounded by Airbus’ decision to offer customers significant
discounts as well as resale price guarantees to spur sales in the early ‘00s. With secondary market
prices as low as $20mm, against original list prices of more than $90mm and a scrap value of probably
$10mm, Airbus has recorded losses of hundreds of millions of dollars. RR has also faced pressure to
retool its LTSAs in order to level the cost of operation with the long-range variants of the competing
Boeing 777, which is powered by the GE90. Airbus believes the plane remains a compelling alternative
for customers looking to retire older 747s, and given the willingness of RR to make operating costs
competitive as well as the significant decline of purchase values, current lease rates for second-hand
A340s should more than offset the comparative lack of fuel efficiency. This potentially lends some
additional life to the in-service A340s as a stop gap for customers awaiting delivery of the 787 or
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which we believe to be a conservative assumption.
The Trent 700 is available as an option on the Airbus A330, competing with the P&W PW4000 and the
GE CF6. The Trent 700 has been a tremendous success on the A330, becoming the preferred engine
option with market share of more than 57%. The success of the Trent 700 mirrors the failures of the
A340 with which it partially competes, and RR continues to deliver large numbers of Trent 700s, with a
significant order book which will be delivered through at least 2015. Given the operational success of the
A330, the comparatively recent vintage of the aircraft, and continuing deliveries of new planes and
engines, we expect that most Trent 700s will remain in service for more than a decade, with the potential
for a large number of engines to remain in service well into the 2030s. We believe the successes of the
Trent 700 and the contemporaneous Trent 800 more than compensate for the relative disappointment of
the A340/Trent 500, and offer a compelling illustration of what the prospective Boeing 787/Airbus
A350XWB sales lifecycles may look like. Furthermore, the success of the A330 has led some observers
to speculate that RR will secure an exclusive for the re-engined A330neo variant that Airbus is reportedly
developing.
The situation of the Trent 800, which powered the earlier variants of the Boeing 777, is similar. We
expect the service profile of the Trent 800 to largely resemble that of the 700, albeit with the potential for
greater numbers of retirements in the latter part of the current decade due to RR having lost its position
on the later, extended range versions of the 777, which are GE-exclusive. To date, the Trent 800 has
won 19% of total 777 family deliveries to date, but this ignores the fact that GE was awarded exclusivity
for the later 777-200LR, -300ER, and F variants, which account for just over ½ of 777s shipped. If one
considers solely the competitive portion of the 777 program, RR’s market share was 40%, comfortably
exceeding the 30% won by GE and P&W individually. We expect that the bulk of the Trent 800s will be
retired in the 2020-2025 timeframe, being replaced by 787s and A350XWBs.
Unfilled Orders - as of May 2014 While RR retains a significant installed base of
Trent 1000 458 Boeing 787 legacy engines, with the Trent 700 continuing to
Trent XWB 1,484 Airbus A350 XWB win new orders after almost 20 years since its
Trent 900 156 Airbus A380 first delivery to a customer, the current installed
Trent 700 292 Airbus A330 base pales in comparison to the prospective
Total: 2,390 weight of the current order book. The most
important airframe platforms for RR in the
coming decades will be the Boeing 787 Dreamliner and the Airbus A350XWB which are powered by the
Trent 1000 and Trent XWB, respectively. These engines power new long-range, twin-engine airframes
which, in the case of the 787, are just completing their first years of service and which still have their best
years ahead of them. The Trent 900-powered A380, on the other hand, has generated many of the
similar customer concerns as the A340, and orders have been weak, despite being a comparatively new
airframe. While Airbus will likely seek to keep the A380 as a viable platform for as long as possible, given
the significant investment in the platform to date, we do not anticipate significant incremental orders for
the Trent 900.
If the Boeing 777/Airbus A330 cycle offers any indication, new deliveries of these nascent twin-engine
widebody platforms will likely continue well into the 2020s, at which point the next generation of twin-
engine widebody aircraft will likely be announced, suggesting that the current order cycle is only 40-60%
complete. While orders for both platforms have tailed off after an initial pre-delivery surge, both
manufacturers will likely retain these designs as core platforms through the 2020s, and we expect
incremental orders to continue to mount as shipments begin to reduce the initial order backlog.
Furthermore, if, as anticipated, Airbus proceeds with the A330neo, RR will likely be able to leverage the
technology of the Trent 1000/XWB into a successor for the Trent 700, further enhancing the return on
investment of the company’s current generation engine programs.
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many of the same issues that plagued the A340 program due to its 4 engine configuration and sheer size,
and is generally regarded as being something of a troubled platform of little interest to all but a handful of
premium long-haul operators. Despite winning an order at the end of 2013 for an additional 50 aircraft
from Emirates, A380 orders appear to have peaked and the aircraft’s future is generally regarded as
being in doubt unless a re-engined A380neo enhances the plane’s economic appeal. The prospective
challenge of re-leasing these aircraft after their initial lease terms expires has been a concern, as has the
potential near-term competition raised by the prospective revamped Boeing 777, the 777x. Airbus and
RR have reportedly held tentative discussions over the possibility of a re-engined A380neo, allegedly at
the urging of Emirates, but there has apparently been some skepticism as to whether it will be possible
for Airbus to pursue an A380neo and an A330neo simultaneously.
Barriers to Entry:
The primary attraction of RR’s business is the sheer size of its competitive moat. All of the current major
competitors in the aircraft engine market date to the early days of aviation in the early 20 th century, and
we believe that a new entrant would likely require state backing and several decades to reach competitive
parity with existing competitors. Indeed, RR itself has been a recipient of government aide over the
years, having received more than £450mm in subsidies from HM Treasury to kickstart the development of
various models of the Trent engine in the ‘90s, and we believe that significantly larger sums would be
required for a greenfield entrant building a wholly new engine architecture. Unless you are an especially
slow-moving endowment investor, this is likely to significantly exceed your investment horizon, and we
think there is little risk of any surprise entrants suddenly disrupting RR’s core markets in the medium term.
Furthermore, in the short term the range of competing products is fixed, being limited to the other
available engine options on each airframe. The long nature of the product cycle means that prospective
competitors can only enter the market once a decade or so, as manufacturers generally design airframes
in close cooperation with engine makers. This means that for any given product cycle, RR faces a fixed
constellation of 1 or 2 competitors at most. This offers an unusual degree of visibility into what the next 5-
10 years will look like for RR, and, given the size of the current order book, we believe a current investor
need not be especially concerned about RR’s success in bidding for the right to power any given future
airframe platform.
Indeed, it will likely not be until the 2020’s that Airbus and Boeing begin to develop replacements for the
787 and the A350XWB, although niche variants, re-engined upgrades, and other incremental bidding
opportunities may materialize, with a re-engined A330neo being the most likely near-term potential
project. Recent comments from Airbus to the effect that they will not be pursuing wholly new airframes,
and instead developing derivatives of existing platforms, have been mirrored by comments from Boeing’s
CEO that there will be no more “moonshots”. These comments and the apparent shift in strategy they
reflect seem to discount a period of tentative retrenchment after the ambitious, and often troubled,
development of this most recent crop of wide-body aircraft.
This long product cycle is driven by technical complexity. Jet engines are extremely complicated pieces
of machinery with tens of thousands of moving parts, complex to the point that no single engineer retains
a comprehensive understanding of any individual engine, with individual component assemblies being the
province of separate teams of engineers working in tandem. The sheer complexity of jet engines means
that current engine designs are generally the iterative evolution of several decades of design work,
reflecting billions of R&D investment and millions of running hours, with truly revolutionary leaps in design
coming only once every few decades. The Trent XWB, for example, took some 2,000+ engineers 10
years from conception to delivery, while the development of the RB211 engine which has formed the
basis for every of RR’s successful widebody engines to date nearly bankrupted the company. P&W’s
more revolutionary recent engine design, the geared turbo fan PW1000G, will likely have taken almost 20
years to deliver if it is delivered on schedule, and itself draws on concepts that were familiar to engineers
as far back as the ‘60s.
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the basis of proven platforms, presents a highly significant barrier to entry but also creates risks. While
the sheer cost of developing engines creates a risk that an engine may fail to win eventual acceptance
with an airframe manufacturer, these investments are not generally permanent losses, as the orphaned
architecture can generally be reused to bid for subsequent platforms. This is indeed what RR did with the
failed Trent 600, which was to become the launch engine for the Airbus A330 in a revamped configuration
as the Trent 700, or with the failed Trent 8104, which would evolve into the Trent 900. Indeed, the
process of technological evolution is a constant one (a 1% p/a increase in fuel efficiency is a commonly
cited ‘Moore’s Law’ of the jet engine industry), and manufacturers persistent R&D spending means that
engines offering incremental improvements are generally able to be developed when bidding
opportunities arise. However, there is risk surrounding any individual aircraft platform program, as the
airframe manufacturer’s shifting requirements may be out of step with an engine manufacturer’s
development cycle, as happened to GE’s attempts to power what would become the Airbus A350XWB
illustrate.
We believe these R&D risks are further mitigated by the range of bidding opportunities offered in an
oligopoloy sector with only 2 other real competitors, none of which have the ability to simultaneously
compete effectively in all segments at once. Combined with structural factors favoring aircraft platforms
with more than 1 engine option, we believe the risk of RR permanently losing its place in the commercial
aerospace engine market is quite small, although a partial loss of market share is certainly possible. If
the example of Pratt & Whitey and McDonnell Douglas are relevant, the most likely factor which would
lead to a partial loss of share is inadequate investment in R&D and attempting to over-stretch dated,
derivative technology past its obsolescence. We do not believe that RR’s current strategic direction
exposes the company to this risk.
Technical barriers to entry are enhanced by the demands of customers. The preference of customers for
purchasing engines bundled with LTSAs means that customers (not to mention the airframe OEM
choosing its engine partners) are making a bet that the engine OEM will not only successfully deliver
engines on time, but will still be around to provide service and replacement parts for several decades.
The nature of LTSAs also requires that a new OEM would have to build a global network of a dozen or so
MRO shops to service customer engines. LTSAs and the current preference for the “razor and blade”
revenue model extend the break-even point for new engine programs by stretching revenues out over
several decades, which further strains the case for a privately-funded new entrant.
The long pay-back period of engine development programs creates some risks should a platform fail to
live up to expectations, but the sunk-cost of the customer in purchasing the aircraft and the limited
secondary market for such commercially challenged aircraft means that these engines will generally
remain in service for sufficient time to remain economic, with pressure instead being reflected from
smaller than anticipated sales volumes. In these circumstances, it is possible that RR would face
pressure to reduce the per mile cost of TotalCare, as has been the case with the largely failed A340
program.
All of these combined factors mean that a new entrant would require decades of sustained losses, which
would likely prove impossible for any democratic government subject to the vagaries of electoral politics
to successful maintain, reducing the range of potential entrants to likely mean one backed by an
authoritarian government. In fact, the Chinese government already has such a plan underway, and
represents the only potential long-term threat to the currently cozy engine oligopoly worth mentioning,
even though we believe it faces a long uphill battle to commercial acceptance.
Aviation Industry Corporation of China (AVIC), although traditionally focused on high-performance
engines for combat aircraft, is reportedly looking to capture share in the civilian aerospace market, and
some analysts reckon that the company could win as much as RMB 100-300bn (~$16-48bn at current
exchange rates) in state subsidies to enhance its development programs. Although we are extremely
skeptical of the Chinese economy, the state of the national balance sheet, and, by extension, the
9
Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/2019government’s ability to continue fund such an extravagantly ambitious long-term program, the potential
political issues for western customers in purchasing engines from a company controlled by the Chinese
military suggest that AVIC’s plans should be regarded with skepticism. These concerns can be
somewhat offset, or perhaps magnified, by the likelihood that AVIC can (and reportedly already has)
resorted to industrial espionage, allowing it to close the competitive gap by the theft of intellectual
property from western competitors. In either case, we believe that even if AVIC were to successfully win
share, it would not until the mid-2020s at the earliest, placing this risk well outside of the time horizons of
most current investors.
Competitive Dynamic – Civil Aerospace:
The aircraft engine business has been an oligopoly since the 1970s, and RR’s competitors are
subsidiaries of large industrial conglomerates: GE Aviation, a subsidiary of General Electric, and Pratt &
Whitney (P&W), a subsidiary of United Technologies. Both companies have histories stretching back into
the early 20th century infancy of aviation, reflecting the significant barriers to new entrants which have, if
anything, grown larger over time. As part of larger conglomerates, both competitors enjoy access to
greater financial resources and, in the case of GE, from the parent’s captive aviation finance unit. This
has historically meant that RR has had to rely solely on its engineering prowess and has been unable to
fall back on the ability to subsidize customers or airframe OEMs in order to win orders. While RR’s
comparative lack of scale creates some risks, we believe these are mitigated by the significant expansion
of the business currently underway, which will give the company the strongest market position, and by
extension the greatest breadth, in its history.
The structure of the aerospace industry means that airframes are generally offered with 2-3 engine
options at launch, although there have been notable exceptions, such as RR’s currently exclusive position
on the A350XWB (although this was more reflective of disagreements with GE rather than a choice by
Airbus). This is because airframe manufactures generally want multiple engine options in order to reduce
development risks (in case a partner fails to produce a viable engine on time, a situation Lockheed faced
when RR teetered on the brink in the early ‘70s), while customers generally want multiple options so as to
enhance negotiating leverage, or to be able to choose an engine with performance parameters that most
closely match the plane’s intended mission. Customer pushback reportedly led Boeing to abandon its
initial plans to offer the 787 with GE as an exclusive engine partner, which offers some certainty that RR
is unlikely to be wholly shut-out from future widebody airframe platforms.
Indeed, we believe that the power of engine manufacturers relative to airframe manufacturers is
increasing over time, as engines comprise the bulk of the operational costs of the aircraft given current
fuel prices. With the bulk of performance improvements increasingly dependent on the innovations of
engine manufacturers, and new engines able to breathe life into largely decades old airframes (as has
been the case with the A320neo), engine manufacturers are ever more critical partners for Boeing and
Airbus. We believe this dynamic has been visible in the case of the A350XWB, where Airbus’ attempts to
solicit bids for engines offering an unusually wide range of thrust options led to GE balking at the potential
development costs and RR committing only after receiving exclusivity.
Engine manufacturers routinely engage in coopetive behavior in order to reduce the risk associated with
individual development programs. RR regularly enters JVs in its defense aerospace business (such as
for the EJ2000 engine provided for the Eurofighter Typhoon, or the TP-400-D6 which powers the Airbus
A400M Atlas), and previously was a participant in the narrowbody aircraft International Aero Engines
(IAE) JV with P&W, MTU Aero Engines, and Japanese Aero Engine Corporation. IAE developed and
produced the highly successful V2500 engine, which powers the Airbus A320, but RR sold its stake in
2012 in order to concentrate the company’s focus on its core widebody engines. We believe the
presence of a number of significant joint ventures between otherwise direct competitors speaks to a
rational industry environment capable of sustaining abnormally high returns on capital.
10
Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/2019Return on Assets (EBIT)
20.0%
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2010 2011 2012 2013
Rolls Royce Aerospace GE Aviation Pratt & Whitney
Prior to 2011, GE Aviation’s results were disclosed along with the company’s healthcare & transportation operations in the
"Technology Infrastructure" segment
It is important to distinguish between the narrowbody and widebody aircraft engine markets when
evaluating the industry’s competitive dynamic. While narrowbody aircraft significantly outnumber
widebody aircraft, the dollar value of the narrowbody market is slightly smaller, while regional and
commercial aircraft are almost wholly insignificant in comparison. Boeing recently estimated the value of
the widebody aircraft market at more than $2.3trn over the next 20 years, against a $2.0trn narrowbody
market and a $80bn regional & commercial market. The narrowbody market is generally more
competitive, with a greater number of second-tier airframe OEMs attempting to compete with the
dominant Boeing and Airbus, including comparatively new, heretofore irrelevant upstarts Bomarbdier
(Canada), Embraer (Brazil), Mitsubishi Aircraft Corporation (Japan), COMAC (China) and United Aircraft
Corporation (Russia). We believe the size of the market opportunity is more than enough to comfortably
sustain 3 engine manufacturers, and that the breadth of the industry precludes domination of all
segments by any given competitor. Furthermore, we believe that it would not be in the interest of
airframe manufacturers to let one of the 3 engine manufacturers disappear, thereby further increasing the
already significant market power of the surviving 2 manufacturers.
The Widebody Market – GE vs. Rolls Royce
RR’s primary widebody competitor is GE Aviation (GE). GE Aviation is the giant of the field for the time
being thanks to its current widebody market share lead as well as its strong competitive position in
narrowbody via the CFM International JV. Like both RR and P&W, GE also maintains a significant
defense aerospace business, with a strong legacy position in combat aircraft. Furthermore, GE has
historically been able to rely on the financial largesse of GE Capital Aviation Services (GECAS), which is
among the world’s largest aviation lenders, offering a competitive advantage in marketing. GE has also in
some cases offered significant direct subsidies to airframe OEMs, as it did with the long-range Boeing
777 variants, for which GE committed up to $500mm in exchange for exclusivity over the proposed Trent
8104, which was generally regarded as the more innovative and advanced engine at the time.
GE competes head to head with RR’s Trent 1000 on the Boeing 787 Dreamliner with its GEnx engine.
The GEnx engine builds on the previously successful GE90 engine and has so far won some 65% of
finalized 787 orders, although a significant number of firm orders remain uncommitted to an engine
supplier. The GEnx retains a somewhat more conventional core design as compared to its primary
competitors, favoring evolutionary, iterative improvements made possible by advancing materials science.
11
Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/2019GE’s engine, at initial specifications, reportedly offers slight advantages compared to the Trent 1000 over
longer distances (>5,500km) due to a modest cruise fuel burn advantage, while the Trent 1000 offers
better fuel efficiency over shorter distances due to improved climb fuel efficiency, which is a product of
RR’s continued usage of three-spool architecture (first employed by RR as far back as the RB211) as
compared to GE’s more conventional two-spool design.
GE/P&W Revenue & Backlog (USD mms.)
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
-
2010 2011 2012 2013
Revenue - GE Revenue - P&W Backlog - GE Backlog - P&W
P&W’s backlog includes an estimate of future service revenues
The extent to which GE’s market share lead on the 787 platform is due to any apparent technical
superiority is questionable in light of the influence of GE Capital. RR maintains a higher market share
among better capitalized airlines as well as with large lessors, suggesting that sophisticated buyers may
believe that RR will retain a lower lifetime cost of ownership, absent any financial incentive provided by
GE’s largesse. Furthermore, as previously mentioned, the question of one engine over another also likely
hinges on the planned mission of the aircraft, meaning that each engine retains advantages for different
length routes and environments, as well as the engine’s reliability, which is obviously not wholly
determinable ex-ante.
The GEnx has not been without teething problems, and the engine suffered several low pressure turbine
failures as well as a serious but contained failure on a GEnx powered 747 freighter, which GE attributed
to weather issues. It is worth noting that these types of issues are not terribly unusual for a new engine
architecture (or for new airframes for that matter), and barring any catastrophic uncontained failures
leading to a high-profile crash, are unlikely to deter customers, as was the case with RR’s Trent 900,
which experienced similar issues on a Quantas A380 flight in 2011. This tentative process of
troubleshooting and tweaking is inherent to engineering challenges of this complexity.
GE reportedly attempted to sell the GEnx to Airbus as an alternative to RR’s Trent XWB for the
A350XWB, with talks supposedly breaking down due to GE’s unwillingness to offer a wholly new,
upgraded engine for the A350XWB for fear of cannibalizing sales of the GE90-115B powered Boeing
777-200LR/300ER on which GE has exclusivity. GE also claims that the commercial logic was strained
due to the gradual upsizing over time of the 350 program by Airbus, with necessitated an increasingly
large range of thrust requirements which effectively demanded a wholly new engine. Given GE’s
previous commitments to the upgraded 777 variants, this was an investment which GE was unwilling to
make, while RR was reportedly only willing to do so after receiving a promise of exclusivity.
GE also competes head to head against the Trent 900 on the Airbus A380 via its Engine Alliance JV with
P&W, which produces the GP7200 engine, and maintains a slight market share advantage over RR with
12
Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/201955% of orders to date. The GP7200, originally an orphan engine developed for the failed 747-500/600x
platform, was re-designed for the 380 as the GP7270 and GP7277. P&W has reportedly been frustrated
by GE’s unwillingness to bid for more airframes for the GP7200, but this is perhaps unsurprising given the
success of GE’s wholly owned, partially competing GEnx, suggesting that the Engine Alliance JV is
unlikely to have much of a future.
GE’s GE90 engine is an older, legacy
product of note, contemporaneous with the GE/P&W EBITDA Margin
Trent 800, and which continues to win 24.0%
orders on Boeing’s durable 777 family of
22.0%
aircraft. The GE90 was originally offered as
20.0%
one of the 3 options on the early 777-200, -
18.0%
200ER, and -300 variants, and competed
16.0%
with the Trent 800 and the P&W PW4000.
14.0%
RR’s initial market share lead on the 777
12.0%
was due to offering a middle ground
10.0%
between the dated technology offered by 2010 2011 2012 2013
the PW4000 and the GE90, which offered
the most modern technology but which was EBITDA Margin - GE EBITDA Margin - P&W
plagued by reliability issues at the time.
However, as Boeing sought to extend the 777 family with several updated, re-engined long range
variants, GE won exclusivity for future 777s by agreeing to contribute some $250mm to airframe
development costs. This move has proven to be wildly successful, as the upgraded, re-optimized
versions of the GE90, such as the GE90-110B1L/115BL/115B, solved the early reliability problems of the
GE90 and have become among the most successful widebody engine platforms to date, exclusively
powering the -200LR, -300ER, and 200F variants.
Pratt & Whitney – A Dormant 3rd Competitor in Widebody with a Narrowbody Foothold
Through the ‘80s and much of the ‘90s, P&W shared the widebody market with GE and RR was a distant
third to the American manufacturers. However, with the exception of its Engine Alliance JV which powers
the A380, P&W has not participated in a significant widebody aircraft platform since the mid ’90s when
the company experienced some limited success with modernized iterations of the older PW 2000 and
PW4000 engines. P&W’s example provides a cautionary tale of how a previously formidable competitor
lost its way by failing to be aggressive enough in investing in new engine architectures.
P&W’s travails started in the narrowbody market with its early failure to successfully win a position on the
Boeing 737 platform in the late ‘60s, losing out to the CFM56 in what was to become the most successful
commercial aircraft program of all-time. P&W would retain a significant foothold in the narrowbody
market, but did so only through the International Aero Engines (IAE) joint venture, of which P&W initially
held less than a 20% equity stake. This meant that P&W was a comparatively marginalized player in the
narrowbody market, a position which became increasingly problematic as the company failed to maintain
the initiative in its widebody engines.
P&W’s attempts to remain competitive in the widebody market by stretching the then-dated architecture of
the PW2000 and the PW4000 (which were contemporaries of the RB211) for the Boeing 757 and 777 in
the ‘90s resulted in these engines remaining 3rd choice options for carriers, winning only limited market
share compared to more modern engines offered by RR and GE. Following these setbacks, P&W took a
significant leap in opting to invest for the long-term in a comparatively radical ‘geared turbo fan’ (GTF)
architecture in hopes of restoring its commercial market share, a move which so far seems to have paid
off. This investment, along with its implications on the future of both the narrowbody and widebody
engine market, will be discussed more fully in the following section along with a more complete
discussion of the narrowbody market.
13
Downloaded from www.hvst.com by IP address 172.20.0.10 on 09/10/2019The Narrowbody Market – Present & Future
Outside of a handful of largely legacy engines powering small corporate and regional aircraft (some of
which remain in production), RR currently has no offering for narrowbody commercial aircraft, having sold
its interest in the highly successful IAE JV. The narrowbody aircraft engine landscape varies significantly
from the widebody market, and is primarily mentioned here to provide some insight into the possibility that
P&W is able to translate its recent success in narrowbody into future widebody engines with its potentially
revolutionary GTF technology. The narrowbody engine market is currently a duopoly between the
previously mentioned IAE JV and CFM International (CFMI), which is a 50:50 JV between GE Aviation
and SNECMA, a subsidiary of Safran SA. However, the competitive logic which sustained IAE has
dissipated and narrowbody will henceforth likely be a two-way contest between CFMI and P&W.
IAE’s sole commercial product was the spectacularly successful V2500 engine, which powers most of the
A320 family of aircraft and the now discontinued McDonnell Douglas MD90, first delivered to customers in
1988 and 1995, respectively. The V2500 competes on the A320 with the CFM International CFM56 and,
on a limited basis, with the P&W PW6000. CFM International’s CFM56, first delivered to defense
customers on a re-engined version of the KC-135R fuel tanker in the early ‘80s, has similarly been one of
the most commercially successful jet engine platforms of all time. The durable CFM56 was initially
developed commercially for the Douglas DC-8, but was to win its greatest success on the highly
successful Boeing 737 platform, as well as an option for variants of the Airbus 320 and as one of the
launch engines for the Airbus A340. These two engines will continue to power the majority of the global
narrowbody fleet for the immediate future.
RR’s widebody success with the Trent engine and the resurgence of P&W as a commercial aviation
competitor made the IAE joint venture a one engine proposition, however, and P&W is set to go it alone in
the narrowbody market with its potentially groundbreaking new engine, the PW1000G. The PW1000G’s
GTF concept, which has been in development since 1998, hopes to demonstrate the commercial
possibility of a concept that dates as far back as the ‘60s, and which has been used in a handful of small
commercial and regional aircraft to partial success. The GTF seeks to eliminate several intermediate
engine stages by the addition of a reduction gearbox, potentially offering significant fuel efficiency savings
through reduced weight at the potential expense of lower reliability.
The PW1000G seems to have won the tentative acceptance of customers so far, with P&W reportedly
recording more than 5,300 orders (including options) as of May 2014. P&W claims that its flight data
suggest performance modestly exceeding their own initial expectations and dismiss claims from CFMI
that its engine will be more expensive to operate due to higher maintenance costs. The acceptance of
the PW1000G by Lufthansa, generally regarded as being exceptionally diligent in its analysis of
prospective engine choices, has been highlighted as evidence that P&W has successfully solved the
engineering challenges of designing a gearbox capable of functioning effectively at the temperatures and
pressures demanded of it. P&W expects the PW1000G to enter service on the A320neo as an alternative
to CFMI’s proposed LEAP engine in Q4 2015 and as an exclusive on the second generation of Embraer’s
E-Jet series in 2018. The PW1000G will also be offered on the Mitsubishi Regional Jet, Bombardier
CSeries, and Irkus MS-21 platforms.
At the risk of oversimplifying, the two competing narrowbody engines are seeking to achieve similar
results by optimizing different criteria: propulsive efficiency in the case of the GTF, and thermodynamic
efficiency in the case of the LEAP engine (see our technical appendix for a more complete discussion of
these 2 engines). The two engines will compete head to head from the start on the Airbus A320neo, with
P&W so far maintaining a narrow lead over GE. It is worth noting that these technologies are by no
means mutually exclusive, and that if the GTF concept is sufficiently successful it is likely to be rapidly
incorporated by GE in future engine designs, on top of the existing thermodynamic efficiency gains made
by GE’s application of more advanced materials. Indeed, RR has already made announcements to this
effect, with its proposed Ultrafan concept incorporating elements of both of these engines for the next
generation of bidding opportunities in the mid-2020s.
14
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