Tufan Erginbilgiç certainly made a splash after he was appointed as chief executive of Rolls-Royce (RR.) at the beginning of this year. His depiction of the engineering group as a “burning platform” was designed to grab the headlines, shake off any complacency on the part of employees, and signal to investors that relative underperformance compared with peers would no longer be tolerated. He may have been drawing a line in the sand, but it’s worth remembering that his predecessor, Warren East, had already cut 9,000 jobs in the wake of the pandemic, so change was already afoot.
Erginbilgiç recently announced that the engineering group was planning to shed another 2,000-2,500 jobs, mainly of the back-office variety, as it seeks to eliminate duplication across the business. We will get more detail on the ongoing transformation later this month when the outcome of the latest strategy review is released to the market.
You wouldn’t wish to underplay the challenge faced by management, but the group did return to profit at the half-year mark, while free cash flow moved into positive territory. Analysts were also pleasantly surprised by order intake for jet engines, no doubt helped along by the steady recovery in air travel passenger numbers.
The group isn’t out of the woods, not least in relation to the balance sheet, yet sentiment towards the stock has certainly improved. At the time of writing the shares were changing hands at around 200p apiece, a 163 per cent increase on this period last year, making it the best-performing constituent within the FTSE 100 index. They also registered a strong technical signal based on moving averages at the end of last year.
That’s not to say that Erginbilgiç has led a charmed life thus far, especially given that his ambitions for the group will not only be achieved through incremental measures — there could be some major changes in prospect. Net debt has contracted appreciably since the 2022 half-year, although total liabilities outstripped assets by 17 per cent at the end of June. It is therefore conceivable that the board could choose to hive off part of the business to bolster the balance sheet. Naturally, this is pure conjecture but it’s worthwhile noting that the 7 per cent underlying operating margin for the power systems arm is well adrift of comparatives for civil aerospace (12.4 per cent) and defence (13.6 per cent), reflecting the proportion of underlying revenue from higher-margin aftermarket services.
US parallels at RTX Corporation
None of this is news to Rolls-Royce shareholders. But the partial recovery in the share price could be instructive when we look at the contrasting fortunes of another engineering group across the Atlantic which also has exposure to the defence and civil aviation markets. There are a couple of interesting parallels.
RTX Corporation (US:RTX) — formerly Raytheon Technologies — came into being in its current form in April 2020 through an all-stock merger with United Technologies, which, among other business units, includes jet engine manufacturer Pratt & Whitney. It is thought that United Technologies wanted to increase its relative exposure to the defence market, a move that looks prescient considering recent events, although US Federal spending continues to outstrip economic growth rates and something must give on the budget front eventually.
The combined group is comprised of three divisions: Collins Aerospace, Pratt & Whitney and Raytheon. Its manufacturing expertise extends but is not confined to aircraft engines, avionics, guided missiles, defence systems, cyber security, satellites and drones.
At a glance, one might easily imagine that RTX has greater exposure to the broader defence sector than Rolls-Royce, but according to the research and networking resource Defence Industry Reports, the UK group is the number two military aero engine manufacturer worldwide, “powering approximately 25 per cent of the world's military fleet” and is the number one military aero engine manufacturer in Europe. In addition, the group’s pressurised water reactor (PWR) series has powered the Royal Navy's nuclear submarines since the Valiant class, commissioned in 1966.
Conversely, the place of Pratt & Whitney within the civil aviation space is sometimes overlooked because of its high-profile activities supplying the defence sector. Indeed, earlier this year it signed a $5.2bn (£4.29bn) contract in March to produce and deliver additional F135 engines for the US F-35 fleet. Yet the company’s engines can also be found on the Airbus A220, A330, Boeing 747-400s, and 767 jets, to name but a few. Next time you’re jetting off to Torremolinos there is a one-in-four chance that you’re being held aloft by a Pratt & Whitney engine. Overall, approximately half of RTX’s revenue comes from non-defence sales. That’s important to short- to medium-term revenue growth given the trajectory of global flight hours since normal services were resumed.
Unfortunately, there is a less welcome parallel between RTX and Rolls-Royce beyond the general overlap in the aviation space. It’s well documented that even prior to the pandemic and the consequent collapse in civil aviation flying hours, Rolls-Royce was struggling with durability issues on its flagship Trent 1000 engines. Consequently, the group was forced to take exceptional charges that ran into the billions due to the technical issues, although at least it was able to use the downtime afforded by the pandemic to pursue remedial work. The impact on revenues from full-service maintenance contracts, or the lack thereof due to the pandemic, was felt by the industry in general, so at least Rolls-Royce was not an outlier on that front — cold comfort indeed. Hopefully, the partial share price recovery might suggest that the Trent 1000 issue can be consigned to the history books.
Now it transpires that Pratt & Whitney — and RTX by extension — is faced by similar problems. Midway through September, it was announced that hundreds of aircraft worldwide would be grounded through to the end of 2026 due to problems with Pratt & Whitney engines which were originally disclosed in July. The recall will amount to an average grounding of 350 aircraft per year, prompting RTX to take a charge of $5.4bn in the third quarter linked to compensation for carriers, although the final bill could be much higher. Whatever the scale of the financial hit, it will have a negative impact on group revenues and cash flows, while hampering expansion efforts by the likes of Airbus SE (FR:AIR) in the process. Yet despite the reduction in cash profit expectations, the group has increased its capital return commitment to $36bn-$37bn through to the end of 2025, from $33bn-$35bn previously.
The news of the charge sent the shares southwards, contributing to the 22 per cent contraction in the year to date, and placing it on a lower forward rating than US peers such as Northrop Grumman (US:NOC) and Lockheed Martin (US:LMT). The group’s price/earnings-to-growth ratio, though hardly compelling at 1.5 times, sits below its five-year average and is superior to the average multiple for the aerospace/defence sector.
And despite the recalls and their immediate financial impact, the projected cash margin of 15.7 per cent will trump the pre-pandemic level. Broker consensus points to a 13 per cent increase in cash profits from the end of this through to December 2024, while net earnings should benefit from a decreased tax charge. RTX has also registered consistent year-over-year revenue growth; sales rose from $56.6bn in 2020 to $64.4bn in 2021 and $67.1bn in 2022.
Geopolitical events support volume growth
The investment case obviously wasn’t enhanced by the multi-year recall, but geopolitical events certainly support volume growth. FactSet data point to an order backlog of approximately $190bn by the end of this year, while new orders are outstripping the movement in finished goods — a positive sign on the demand front. A positive book-to-bill ratio could support anecdotal reports that the US and other countries supplying arms to Ukraine have stretched their arsenals to worrying levels.
It’s difficult to substantiate any such reports given the inherent secrecy surrounding defence procurement, but Raytheon — a leading manufacturer of air-, sea-, and land-launched missile systems — continues to garner orders under the Ukraine Security Assistance Initiative.
Midway through this year, it had already received $2bn in replenishment orders due to the ongoing conflict. And although it may seem distasteful to some, the aerospace and defence sector was marked up appreciably in the immediate aftermath of Hamas’s 7 October attack on Israel. Raytheon supplies missiles for Israel’s Iron Dome defence system, and in a recent earnings call, RTX chief executive, Greg Hayes, said President Biden's request for a defence budget increase in 2024 “seems to fit quite nicely with the Raytheon defence portfolio”.
Even after the Pratt & Whitney hit to the share price, it would be unrealistic to imagine that RTX’s share price — down 25 per cent on its April 2022 high-water mark — will stage a partial rally in line with that of Rolls-Royce. After all, the British aerospace giant was operating from a much lower base. Yet comparisons with industry peers across a range of metrics indicate that now could be a good time to gain exposure to a group whose prospects are intertwined with rising defence budgets and the projected increase in civil aviation passenger numbers.
