Long Rolls Royce Holdings plc (LSE:RR)

April 2016
Luis Sanchez
luisvsanchez@gmail.com

Company Overview
Business Description

Business Segments
Civil Aerospace

Defense Aerospace

Wide body jet engines

Engines for military aircrafts

Rolls-Royce is a global producer of engines for

aerospace, maritime, and power generation
The companys crown jewel is its Civil Aerospace
business where it is #2 in wide body engines

Rolls-Royce also has strong market positions in

defense aerospace and nuclear submarine engines
Rolls-Royce is based in the United Kingdom

Power Systems

Marine

Nuclear

Back-up power

Ships used in offshore oil

Royal Navy
submarines

Financial Summary
Capitalization
Market Cap

Financials
2015 Sales

13,354

EV/2015 EBITDA

5.9x

Cash

3,178

Backlog

76,399

EV/2016E EBITDA

8.5x

Debt

3,398

2015 EBITDA

2,105

EV/2016E Sales

0.9x

EBITDA Margin

15.8%

Price/2016E EPS

24.6x

Enterprise Value

12,227

Valuation

12,447

Sales Mix

Projections based on analyst consensus estimates. Data as of 4/15/2016.

( in millions)

2010

2011

2012

2013

2014

2015

Sales

10,866

11,277

12,209

15,505

13,864

13,354

6.4%

3.8%

8.3%

27.0%

(10.6%)

(3.7%)

59,200

57,630

60,146

71,612

73,674

76,399

% of sales

545%

511%

493%

462%

531%

572%

EBITDA

1,346

1,574

1,898

2,367

2,281

2,105

Growth %
Backlog

Margin %
Free Cash Flow
ROIC

12.4%
714
12.8%

14.0%
581
12.4%

15.5%
548
14.9%

15.3%
781
16.7%

16.5%
254
13.3%

15.8%
179

Marine
10%

Nuclear
5%

Power
Systems
18%
Defense
Aero
15%

EBIT Mix
Marine
1%

Nuclear
5%

Power
Systems
13%
Civil
Aero
52%

Defense
Aero
26%

Civil
Aero
55%

11.3%

Investment Thesis
Summary Thesis
Rolls-Royce has the best wide body aircraft engines in production and
its Civil Aerospace business is expected to become the market leader
in wide body engines within the next 5 years

Excessively negative sentiment around Rolls-Royces stock has

developed due to short term earnings headwinds from a temporary
lull in engine shipments and complex accounting
The companys massive 76 billion backlog highlights the significant
value of a predictable stream of future cash flow

The new CEO, Warren East, had a strong track-record of creating

shareholder value at ARM Holdings and is well positioned to affect
significant change at Rolls-Royce coming in as an outsider
A break-up of the company could result from the emergence of activist
investor ValueAct as the companys largest shareholder

A sum-of-the-parts valuation approach implies 40% to 75% upside to

the current share price

A Sum-of-the-Parts Model Implies Upside of 40% to 75%

Valuation Summary
Marine
2014 Revenue
2015 Revenue
Avg. Revenue
Revenue Multiple
Valuation

Low
1,709
1,324
1,517
1.0x
1,517

Defense Aerospace
High
1,709
1,324
1,517
1.5x
2,275

Power Systems
2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
440
361
400
6.0x
2,400

Marine and Power Systems

operate in cyclical markets
without competitive
advantages. In a break-up
scenario, these two units
would be the first to go

2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
385
416
400
8.0x
3,203

Civil Aerospace
High
385
416
400
10.0x
4,003

Nuclear
High
440
361
400
8.0x
3,200

2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
67
86
76
7.0x
534

High
67
86
76
9.0x
686

Low
10,753

High
12,281

10.0%
3.0%

10.0%
4.0%

Sum of the Parts

Low

High

Civil Aerospace
Defense Aerospace
Power Systems
Marine Systems
Nuclear
Enterprise Value
Net Debt
Equity Value

10,753
3,203
2,400
1,517
534
18,406
811
17,595

12,281
4,003
3,200
2,275
686
22,445
811
21,634

Current Market Cap

Upside

12,227
43.9%

12,227
76.9%

6.65
9.57

6.65
11.77

DCF Model Valuation

Assumptions:
Discount Rate
Long-term growth

Share Price on 4/15/16

Target Price Range

Defense Aerospace and

Nuclear are niche businesses
with attractive economics

Civil Aerospace is the crown jewel asset.

The Civil Aerospace business alone is
worth the companys market cap
4

Civil Aerospace Segment Overview

Business Description
Focuses on wide body engines for commercial
aircraft operators
Also sells engines for the corporate and regional jet
markets
Currently has the most efficient wide body engines
in production and is gaining market share
The wide body engine install base is expected to
grow by over 50% in the next 10 years as a result of
business already won as the sole provider for
Airbuss next generation aircraft frames
Beyond the current sales cycle, Rolls-Royce has a
strong pipeline of engines (Trent 1000/XWB/7000)
Projected Ramp in Wide Body Engine Install Base

Segment Financials
( in millions)

2010

2011

2012

2013

OE Revenue
1,892
2,232
2,934
3,035
% OE
38.5%
40.1%
45.6%
45.6%
Services Revenue
3,027
3,340
3,503
3,620
% Services
61.5%
59.9%
54.4%
54.4%
Total Revenue
4,919
5,572
6,437
6,655
Growth %
9.8%
13.3%
15.5%
3.4%
Backlog
47,000
48,490
51,942
49,608
% of sales
955%
870%
807%
745%
Gross Profit
Gross Margin %
EBIT
392
499
743
708
% of sales
8.0%
9.0%
11.5%
10.6%
EBITDA
626
747
1,027
1,043
% of sales
12.7%
13.4%
16.0%
15.7%
Capex & Intangibles
568
620
581
891
% of sales
11.5%
11.1%
9.0%
13.4%
Note: segment financials have been adjusted for corporate overhead.

2014
3,463
50.7%
3,374
49.3%
6,837
2.7%
60,296
882%
1,675
24.5%
942
13.8%
1,227
17.9%
836
12.2%

2015
3,258
47.0%
3,675
53.0%
6,933
1.4%
63,299
913%
1,526
22.0%
812
11.7%
1,127
16.3%
668
9.6%

Lucrative Aftermarket Engine Services

Over 80% of value is captured through aftermarket
maintenance service contracts (MRO)

Engines are sold at a loss with the expectation of

locking in MRO contracts with 10 to 25 year terms
Aircraft operators make quarterly subscription-like
payments for engine maintenance and service
The company collects engine performance data in
real time and alerts operators of service needs

Source: Rolls-Royce company filings

Over the life of an MRO contract, each engine

generates significant and predictable cash flows

Civil Aerospace has an Extremely Attractive Industry Structure

Aircraft Engine Demand is Growing
Air traffic is projected to grow 3% - 4% per year
over the next 30 years (1)
Projected Aircraft Deliveries

Strong Competitive Position

Wide body is a duopoly between GE and RollsRoyce; Pratt & Whitney has a small presence
Industry participants are rational and predictable
Rolls-Royces market share of wide body is ~31%
and is expected to rise to over 50% within 5 years
Bears argue that Rolls smaller scale and lower
margins are evidence of competitive disadvantage

Source: Boeing Current Market Outlook 2015.

Barriers to Entry Are Prohibitively High

Developing an engine line requires over $1bn of
R&D and could take more than 10 years (2)
Multi-year contract bidding process is expensive

Rolls-Royces recent success in winning major

new engine contracts disproves the claim
Rolls competitive position could be strengthened
if cost reduction programs are successful
Total Aerospace Sales
and EBIT Margins(3)
20.7%

Operators are captive to long-term MRO contracts

and engines cannot be switched out once installed
For operators, switching costs include re-training
staff and investing in new servicing infrastructure

13.8%

10.2%

$24

$15

$13

2014

2014

2014

GE

P&W

RR

(1) Global Air Transport Outlook to 2030, International Civil Aviation Organization.
(2) Gearing up for a fight, The Economist, January 25, 2014.
(3) Represents total civil and defense aerospace platforms. Assumes $1.44 GBP / USD exchange ratio.

Margin and scale

gap should be
viewed as an
opportunity

A Lull in Engine Deliveries and Complex Accounting Hides Value

Segment Headwinds are Temporary
Rolls-Royce is transitioning from older engine lines
to newer models (Trent 1000 / XWB / 7000)
The time lapse in between the transition has created
short-term headwinds for growth and earnings
The lull is exacerbated by a change in accounting
whereby profits on new engines are recognized later
Soft demand resulting from slowing global growth
has also contributed to recent market headwinds.
Some older aircrafts have been retired early and
demand for corporate jets is down

350
Engine Deliveries (units)

300

Accounting Complexities Hide Value

Rolls-Royce sells engines as linked or unlinked
Linked sales occur when the engine and MRO
contract are sold as a package
Unlinked sales occur when the engine is sold first
and the MRO contract is added on
Engines sold on new programs are primarily
unlinked because Airbus changed its sales process
In unlinked contracts, losses from the sale of engines
below production costs are recognized sooner,
creating a headwind to earnings
Both linked and unlinked contracts use percentage
of completion accounting for the MRO contract but
flow through different line items in the financials

Current lull in Rolls-Royce

Engine deliveries is temporary

250

The various moving parts of the two methodologies

have created headaches for financial analysts

200
150

The company recently responded to complaints by

increasing accounting disclosures, including detailed
schedules of Civil Aerospace segment cash flows

100

50
0
2006
2008
Trent 700

2010
2012
Trent 1000

2014
2016
Trent XWB

2018
2020
Trent 7000

Cash flow economics have not changed

7

Civil Aerospaces Valuation is Misunderstood by the Market

The Sell-Side is Too Short-Term Oriented

DCF Valuation and Key Assumptions

Only 2 of 25 sell-side analysts have buy ratings

Civil Aerospace

Analysts are aware of their short-termism:

We value Rolls-Royce more on a short-term than
a long-term basis. For 2017, a year of earnings
recovery, Rolls-Royce is trading at a premium to
the market, (PE 17 of 14.4x vs 11.4x for the
sector), and is even higher after restating the
accounts with more standard accounting
methods. 2/15/16
We see scope for margins & cash to increase off a
very depressed base in 2016E, although with the
stock trading on ~14x 2017E EV/EBIT (>25%
premium to the sector), we argue that this upside
appears priced in. Maintain Neutral. 2/24/2016
Over the last 12 months longer, to be honest
we understand our research did not resonate. In
particular, earnings were the measure of success
and we were not treating earnings with enough
respect. 3/3/2016

DCF Model Valuation

Assumptions:
Discount Rate
Long-term growth

High
12,281

10.0%
3.0%

10.0%
4.0%

Average revenue growth of 4% over next 10 years

Segment cash burn of 933mm through 2018

Gradual build towards 16% EBIT margins by 2025

(in-line with P&W, below GE Aero) resulting from a
higher mix of services revenue and cost cutting

Comparable Companies
Company Name
BAE Systems

Enterprise

Market

2016E

2016E

'16 Sales

2016E

Value

Cap

EV / EBITDA

P/E

Growth

EBITDA %

17,851

16,414

8.3x

13.0x

8.7%

11.7%

Meggitt

4,249

3,195

9.3x

12.5x

11.8%

24.8%

Safran

21,370

20,177

8.1x

15.7x

(0.9%)

18.4%

Honeywell

64,678

61,235

11.1x

17.5x

5.2%

20.7%

Thales

11,512

12,793

8.5x

18.3x

4.9%

11.7%

United Technologies

71,412

61,022

9.6x

16.2x

1.3%

18.9%

4,235

3,378

9.1x

13.8x

6.0%

12.6%

9.1x 15.7x

5.2%

18.4%

MTU Aero Engines

Simply slapping an earnings multiple on 1 2 year

estimates does not capture the long-term value from
the ramp in aftermarket cash flows

Low
10,753

Median
Rolls-Royce (Wall St.)

17,851 16,414
12,447

12,227

8.5x

24.6x

(3.1%)

11.0%

Source: Capital IQ, Wall Street consensus estimates. Data as of 4/15/2016.

Defense Aerospace Segment Overview

Business Description
Leading engine maker for military transport
aircrafts and is #2 in defense aero-engines globally
Transport and patrol aircrafts have resilient demand
during both peace and war time
Leading Vertical Lift technologies have provided a
strong position on next-gen combat fighter jets
A $600 million investment in the Indianapolis
facility is expected to improve asset efficiency
Management claims significant R&D synergies
between Defense and Civil Aerospace segments

Segment Financials
( in millions)

2010

2011

2012

2013

OE Revenue
1,020
1,102
1,231
1,385
% OE
48.0%
49.3%
50.9%
53.5%
Services Revenue
1,103
1,133
1,186
1,206
% Services
52.0%
50.7%
49.1%
46.5%
Total Revenue
2,123
2,235
2,417
2,591
Growth %
0.1%
5.3%
8.1%
7.2%
Backlog
6,506
6,035
5,157
4,071
% of sales
306%
270%
213%
157%
Gross Profit
Gross Margin %
EBIT
309
376
395
424
% of sales
14.6%
16.8%
16.3%
16.4%
EBITDA
338
414
425
471
% of sales
15.9%
18.5%
17.6%
18.2%
Capex & Intangibles
53
70
126
103
% of sales
2.5%
3.1%
5.2%
4.0%
Note: segment financials have been adjusted for corporate overhead.

2014
816
39.4%
1,253
60.6%
2,069
(20.1%)
4,564
221%
567
27.4%
366
17.7%
385
18.6%
78
3.8%

2015
801
39.4%
1,234
60.6%
2,035
(1.6%)
4,316
212%
579
28.5%
393
19.3%
416
20.4%
84
4.1%

Defense Aftermarket is Also Lucrative

Sales Mix

Other
21%

Transport
and
Patrol
43%

Defense has a more attractive cash flow profile than

civil because R&D is customer funded
Engines for the KC-130J
Tanker-Transporter

Long product cycles with the production phase

lasting up to 20 to 30 years, including upgrades
Original equipment is sold at a loss, but reaches
cash flow breakeven within 2 years

Combat
36%

Engines for the

Typhoon Fighter Jets

A higher proportion of services revenue increases

the segments stability and cash flow generation
9

Defense Aerospaces Outlook and Valuation

Defense Spending Outlook has Improved
The Congressional Budget Office projects the US
Defense budget to be flat from 2016 through 2020
~50% of Defense revenue is from US government
The threat of terrorism from ISIS in Europe has put
upward pressure on European defense budgets
Rolls-Royce has significant exposure to the UK
where the defense budget was just raised by 6.7%

Comparable Companies
Company Name
BAE Systems

Enterprise

Market

2016E

2016E

'16 Sales

2016E

Value

Cap

EV / EBITDA

P/E

Growth

EBITDA %

17,851

16,414

8.3x

13.0x

8.7%

11.7%

Meggitt

4,249

3,195

9.3x

12.5x

11.8%

24.8%

Safran

21,370

20,177

8.1x

15.7x

(0.9%)

18.4%

Honeywell

64,678

61,235

11.1x

17.5x

5.2%

20.7%

Thales

11,512

12,793

8.5x

18.3x

4.9%

11.7%

United Technologies

71,412

61,022

9.6x

16.2x

1.3%

18.9%

4,235

3,378

9.1x

13.8x

6.0%

12.6%

9.1x 15.7x

5.2%

18.4%

MTU Aero Engines

Median

17,851 16,414

Rolls-Royce (Wall St.)

12,447

12,227

8.5x

24.6x

(3.1%)

11.0%

Source: Capital IQ, Wall Street consensus estimates. Data as of 4/15/2016.

Defense spending is expected to continue growing

in emerging market countries
Historical and Projected US Defense Budget

Segment Valuation
Defense Aerospace
2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
385
416
400
8.0x
3,203

High
385
416
400
10.0x
4,003

Source: US Congressional Budget Office.

10

Nuclear Segment Overview

Business Description

Segment Financials

Sole provider for Great Britains submarine fleet

Also serves nuclear power plants with reactor
support services and safety systems. Supplies
content on ~50% of global nuclear power plants
The monopoly on British nuclear submarines is an
attractive business that may not meaningfully grow,
but will continue to generate strong returns
The segment also enjoys a strong aftermarket
Rolls-Royce would likely be unable to divest its
submarine business due to political reasons

( in millions)

2010

2011

2012

2013

2014

OE Revenue
236
% OE
35.4%
Services Revenue
431
% Services
64.6%
Total Revenue
667
Growth %
Backlog
2,617
% of sales
392%
Gross Profit
Gross Margin %
EBIT
% of sales
EBITDA
% of sales
Capex & Intangibles
% of sales
Note: segment financials have been adjusted for corporate overhead.

230
36.1%
408
63.9%
638
(4.3%)
2,499
392%
119
18.7%
50
7.8%
67
10.5%
23
3.6%

2015
251
36.5%
436
63.5%
687
7.7%
2,168
316%
111
16.2%
70
10.2%
86
12.5%
18
2.6%

Comparable Companies
Sales Mix

Segment Valuation
Company Name

Nuclear
Civil 20%

Subs
80%

2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
67
86
76
7.0x
534

High
67
86
76
9.0x
686

Enterprise

Market

2016E

2016E

'16 Sales

2016E

Value

Cap

EV / EBITDA

P/E

Growth

EBITDA %

Fincantieri

1,828

479

18.4x

NM

4.9%

2.9%

BWX Technologies

2,512

2,403

12.1x

21.7x

3.2%

20.5%

32,238

30,975

10.3x

22.4x

(2.0%)

12.9%

2,854

2,392

9.9x

18.8x

(0.2%)

18.9%

General Dynamics

29,968

29,542

9.2x

14.6x

1.0%

14.8%

Huntington Ingalls

5,005

4,742

7.8x

15.1x

(0.5%)

13.2%

3,929

3,573

12,447

12,227

ABB Ltd.
Curtiss-Wright

Median
Rolls-Royce (Wall St.)

10.1x 18.8x
8.5x

24.6x

0.4%
(3.1%)

14.0%
11.0%

Source: Capital IQ, Wall Street consensus estimates. Data as of 4/15/2016.

11

Power Systems Segment Overview

Business Description

Segment Financials

Provides propulsion systems for maritime and rail.

Also produces onsite power backup systems
Participates in cyclical and fragmented markets.
Rising competition from low-cost Asian producers
The segment is sub-scale and does not enjoy
meaningful competitive advantages
Recent financial performance has been weak due to
exposure to oil & gas
The business was formed out of a JV with Daimler
in 2011. In 2014, Daimler exercised a put option
and Rolls-Royce purchased the remaining stake for
1.9bn (considered a bargain purchase)

( in millions)

2010

Defense
& Other
12%

Industrial
21%

Energy
30%

Segment Valuation
Power Systems

Marine
37%

2014 EBITDA
2015 EBITDA
Avg. EBITDA
EBITDA Multiple
Valuation

Low
440
361
400
6.0x
2,400

2013

2014
1,893
69.6%
827
30.4%
2,720
(6.6%)
1,971
72%
742
27.3%
253
9.3%
440
16.2%
144
5.3%

2015
1,618
67.8%
767
32.2%
2,385
(12.3%)
1,928
81%
635
26.6%
194
8.1%
361
15.1%
108
4.5%

Enterprise

Market

2016E

2016E

'16 Sales

2016E

Value

Cap

EV / EBITDA

P/E

Growth

EBITDA %

Caterpillar

55,319

32,515

16.1x

21.9x

(12.6%)

12.0%

Cummins

14,052

13,932

8.0x

15.1x

(7.3%)

14.2%

Siemens

72,524

60,704

9.1x

14.7x

4.1%

12.5%

Nuclear
55,319

32,515

9.1x 15.1x

(7.3%)

12.5%

(3.1%)

11.0%

Median

High
440
361
400
8.0x
3,200

2012

Comparable Companies
Company Name

Sales Mix

2011

OE Revenue
1,938
2,004
% OE
70.1%
68.8%
Services Revenue
827
908
% Services
29.9%
31.2%
Total Revenue
2,765
2,912
Growth %
5.3%
Backlog
1,823
1,927
% of sales
66%
66%
Gross Profit
Gross Margin %
EBIT
109
296
% of sales
3.9%
10.2%
EBITDA
109
561
% of sales
3.9%
19.3%
Capex & Intangibles
11
142
% of sales
0.4%
4.9%
Note: segment financials have been adjusted for corporate overhead.

Rolls-Royce (Wall St.)

12,447

12,227

8.5x

24.6x

Source: Capital IQ, Wall Street consensus estimates. Data as of 4/15/2016.

Rolls-Royce acquired Daimlers 50% share of the

Power Systems business in 2014 for ~7x EBITDA.
Implies the business is worth 2.8 billion today
12

Marine Segment Overview

Business Description

Segment Financials

Provides propulsion and handling systems to

marine, offshore oil & gas, and naval markets

( in millions)

Operates in competitive markets and is sub-scale

Financial performance has deteriorated as a result
of exposure to offshore oil & gas
The business burned ~$100 million of cash in 2015
and is expected to continue burning cash
Announced a restructuring program to reduce
headcount and cut $65 million in costs by 2017

2010

2011

2012

2013

OE Revenue
1,719
1,322
1,288
1,288
% OE
66.3%
58.2%
57.3%
63.2%
Services Revenue
872
949
961
749
% Services
33.7%
41.8%
42.7%
36.8%
Total Revenue
2,591
2,271
2,249
2,037
Growth %
0.1%
(12.4%)
(1.0%)
(9.4%)
Backlog
2,977
2,737
3,954
1,622
% of sales
115%
121%
176%
80%
Gross Profit
Gross Margin %
EBIT
332
287
294
233
% of sales
12.8%
12.6%
13.1%
11.4%
EBITDA
383
335
337
292
% of sales
14.8%
14.7%
15.0%
14.3%
Capex & Intangibles
65
75
101
23
% of sales
2.5%
3.3%
4.5%
1.1%
Note: segment financials have been adjusted for corporate overhead.

2014

2015

1,070
62.6%
639
37.4%
1,709
(16.1%)
1,567
92%
425
24.9%
138
8.1%
163
9.5%
36
2.1%

773
58.4%
551
41.6%
1,324
(22.5%)
1,164
88%
260
19.6%
15
1.1%
116
8.8%
36
2.7%

A divestiture of Marine would lift the value of the

overall company and free up managements time

Comparable Companies
Sales Mix

Segment Valuation
Company Name

Merchant
24%

Offshore
O&G 56%

2014 Revenue
2015 Revenue
Avg. Revenue
Revenue Multiple
Valuation

Cap

1,828
479
Defense Aerospace

SBM Offshore

Low
1,709
1,324
1,517
1.0x
1,517

Market

Value

Fincantieri

Marine
Naval
20%

Enterprise

High
1,709
1,324
1,517
1.5x
2,275

Wrtsil

6,510

2016E
2016E
EV/EBITDA EV/Sales

'16 Sales

2016E

Growth

EBITDA %

18.4x

0.5x

4.9%

2.9%

2,016

12.7x

NM

(12.6%)

31.1%

6,753

6,412

11.1x

1.7x

1.8%

15.0%

15,393

14,142

19.4x

2.0x

(30.3%)

10.4%

Huntington Ingalls

5,005

4,742

7.8x

1.0x

(0.5%)

13.2%

Saipem

7,425

2,977

7.3x

0.9x

(8.6%)

12.2%

Alfa Laval AB

5,950

4,919

10.7x

1.9x

(10.1%)

18.0%

6,510

4,742

11.1x

1.3x

(8.6%)

13.2%

12,447

12,227

8.5x

0.9x

(3.1%)

11.0%

Baker Hughes

Median
Rolls-Royce (Wall St.)

Source: Capital IQ, Wall Street consensus estimates. Data as of 4/15/2016.

13

Newly Appointed CEO Warren East Brings an Outsiders Perspective

Track Record at ARM

Plans at Rolls-Royce

Warren East is an engineer by training

and has spent most of his career in
the semiconductor design industry
Mr. East served as CEO of ARM
Holdings from 2001 to 2013
Transformed ARM Holdings from a small firm with 1
product line to the worlds #1 mobile chip designer
During his 12 year tenure as ARM CEO, Warren
grew both revenue and EBITDA by 14% per year
Barrons list of the worlds 30 best CEOs in 11 & 13
Described as a low-key operator who eschewed the
rock star persona adopted by other tech CEOs (1)
ARMs Stock Performance Under East
ARMs stock greatly outperformed
during Easts 12 year tenure

+269%
+132%
+32%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(1)

ARM
UK FTSE 100
Nasdaq Composite
Warren East retires as ARM Holdings chief executive, The Telegraph, March 19, 2013.

Warren East joined the Rolls-Royce Board in 2014

and was appointed CEO on July 1, 2015

After conducting a thorough operational review,

East noted the opportunity for significant cost cuts
Announced plans to layoff 20% of employees from
the top 2 levels of management
Announced plans to downsize the Civil Aerospace
manufacturing footprint by 20% to improve
efficiency
Is Warren East the Right Person to Lead?
Rolls-Royce is known for a spendthrift culture
where engineers run up research budgets on nonrevenue generating projects
Given the lack of financial accountability and
cultural change needed, a proven outsider is the
ideal candidate
Warrens track-record managing a rapidly growing
global engineering business is extremely relevant to
the current challenges facing Rolls-Royce
14

ValueActs Involvement Will Help Catalyze Change

ValueAct Capital Overview

ValueActs Investment in Rolls-Royce

ValueAct is known as one of the most successful

activist investors and has filed 66 13Ds since 2000

Announced its stake after Warren East became CEO

and is now the largest shareholder with 10%

ValueAct runs a concentrated portfolio and focuses

on operational change and capital allocation

Rolls-Royce is ValueActs second largest investment,

representing 14% of its portfolio

On average, ValueAct has generated 49% returns on

its 13D investments vs. 24% for the S&P 500 (1)

On March 2, 2016, Rolls-Royce appointed a

ValueAct representative to the Board

Recent Activist Investments

Adobe
ValueAct took a Board seat and pushed company to
2011 - 2012
re-focus on mobile and SAAS products

Rolls-Royce has a fragmented shareholder base and

lacks large insider ownership. This will help
ValueAct swing its weight around the Board room

Likely Outcomes

ValueAct realized a 140% return on its investment(1)

Still owns shares 6 years later
Motorola ValueAct took a Board seat and pushed the company
to divest noncore assets and buyback stock
2011 - 2016

ValueAct realized a 54% return on its investment(1)

Still owns shares 6 years later
Microsoft ValueAct took a Board seat and pushed the company
to buyback stock and focus on enterprise software
2013 - 2014

Oversaw replacement of CEO Steve Ballmer

Shares up over 80%; still owns shares 3 years later
(1)
(2)

It has been widely reported that ValueAct is

pushing for the divestiture of non-core assets,
although the company has publicly commented
that it is not exploring a break-up (2)
Beyond a break-up scenario, ValueAct will help
catalyze a deep restructuring of the firms cost base
and hold the management and Board accountable
ValueAct has an excellent track record of helping
companies improve operating margins and capital
allocation

According to 13D Monitor.

Rolls-Royce Names Activist Shareholder ValueAct to Board, Vows No Change to Strategy, Wall Street Journal, March 28, 2016.

15

Issues Raised by Bears are Manageable

Key Risks and Mitigants
Slow down in global GDP growth reduces demand
Long term air traffic demand growth has been consistent
Two of the worst periods for air travel were after 9/11
and during the 2008 financial crisis. In each of these
periods, air traffic declined by less than 3%
Most revenue is tied to maintenance which is less cyclical
Service contracts have minimum payment requirements
which are not much lower than projected levels
Lower profitability enables competitors to under-bid RollsRoyce on future Aerospace contracts
The oligopolistic industry structure has rational players
Recent platforms wins disprove the argument
Low margins should be viewed as an opportunity
Management team is unproven
Warren East had an excellent track record growing a
global business and delivering shareholder value

Failure to secure MRO contracts

The nature of unlinked contracts does not imply that
MRO contracts are at risk, it is purely accounting parlance
Virtually all Rolls-Royce engines are under contract
Rolls-Royces ability to monitor engine data in real time
and provide OEM replacement parts is uncontestable
Accounting is complex and based on estimates
The companys accounting methods are in-line with how
peers treat long term service contracts and OE sales
The collection of engine data enhances estimate accuracy
Rolls-Royce bakes in a significant margin of error in its
projections of future profitability and cash flow
For example, the company does not bake in future
benefit from cost reductions until they are realized. In
2014 and 2015, the company realized 203mm and
323mm in profits for under-estimating contract values
Rolls-Royce could lose its technological edge in aerospace

An outsiders perspective is needed at Rolls-Royce due to

the need for significant change

The markets the company operates in (civil/defense

aerospace, nuclear) have multi-decade product cycles

Strong fundamentals make this business hard to screw-up

The technology is evolutionary, not revolutionary. RollsRoyce has built upon its three-spool engine for decades
16

Conclusion: Rolls-Royce is a High-Quality Company Available at an Attractive Valuation

Investment Highlights
Exposure to growing markets insulated from
competitive forces

High barriers to entry and switching costs

Significant growth locked-in from backlog
Predictable stream of future cash flows

Attractive valuation misunderstood by

myopic sell-side analysts
Upside from operational improvements

Compelling Valuation

Sum of the Parts

Low

High

Civil Aerospace
Defense Aerospace
Power Systems
Marine Systems
Nuclear
Enterprise Value
Net Debt
Equity Value

10,753
3,203
2,400
1,517
534
18,406
811
17,595

12,281
4,003
3,200
2,275
686
22,445
811
21,634

Current Market Cap

Upside

12,227
43.9%

12,227
76.9%

6.65
9.57

6.65
11.77

Share Price on 4/15/16

Target Price Range

Strong CEO in place

Potential to monetize from a break-up

The significant discount to intrinsic value provides

investors with a substantial margin of safety

17

Appendix

18

Civil Aerospace Segment Discounted Cash Flow Model

Civil Aerospace Segment Discounted Cash Flow Model
2016E

2017E

2018E

2019E

2020E

2021E

2022E

2023E

2024E

Sales
Growth %

6,859
(1.1%)

7,094
3.4%

7,745
9.2%

8,066
4.1%

8,360
3.6%

8,648
3.4%

8,921
3.2%

9,240
3.6%

9,549
3.4%

9,822
2.9%

10,166
3.5%

2016 - 2025 CAGR is 4%; below guidance and sell-side consensus

EBIT
Margin %

276
4.0%

435
6.1%

687
8.9%

884
11.0%

1,099
13.1%

1,269
14.7%

1,336
15.0%

1,419
15.4%

1,496
15.7%

1,572
16.0%

1,627
16.0%

Terminal EBIT margin is consistent with current profitability of peers

D&A
% of Sales

450
6.6%

550
7.8%

675
8.7%

772
9.6%

871
10.4%

971
11.2%

1,068
12.0%

1,063
11.5%

994
10.4%

913
9.3%

813
8.0%

EBITDA
Margin %
Tax Rate
Taxes
Net Working Capital
% of Sales
TotalCare Net Debtor
% of Sales
CARs Additions
% of Sales
Capex
% of Sales
Unlevered FCF
Period
Discount Factor
PV of Cash Flow

726
10.6%
26.0%
(72)
(412)
6.0%
(133)
(1.9%)
(210)
3.1%
(500)
7.3%
(600)
0.25
0.976
(586)

985
13.9%
26.0%
(113)
(355)
5.0%
(71)
(1.0%)
(280)
3.9%
(500)
7.0%
(334)
1.25
0.888
(297)

1,362
17.6%
26.0%
(179)
(310)
4.0%
(46)
(0.6%)
(390)
5.0%
(500)
6.5%
(62)
2.25
0.807
(50)

1,655
20.5%
26.0%
(230)
(242)
3.0%
26
0.3%
(420)
5.2%
(500)
6.2%
290
3.25
0.734
212

1,970
23.6%
26.0%
(286)
(167)
2.0%
67
0.8%
(440)
5.3%
(500)
6.0%
644
4.25
0.667
429

2,240
25.9%
26.0%
(330)
(86)
1.0%
114
1.3%
(450)
5.2%
(500)
5.8%
987
5.25
0.606
599

2,404
26.9%
26.0%
(347)
0
0.0%
118
1.3%
(428)
4.8%
(500)
5.6%
1,248
6.25
0.551
688

2,481
26.9%
26.0%
(369)
46
(0.5%)
121
1.3%
(400)
4.3%
(500)
5.4%
1,380
7.25
0.501
691

2,490
26.1%
26.0%
(389)
95
(1.0%)
122
1.3%
(368)
3.8%
(500)
5.2%
1,452
8.25
0.456
661

2,484
25.3%
26.0%
(409)
147
(1.5%)
138
1.4%
(330)
3.4%
(500)
5.1%
1,532
9.25
0.414
634

2,440
24.0%
26.0%
(423)
152
(1.5%)
102
1.0%
(305)
3.0%
(508)
5.0%
1,458

Sum of PV Cash Flows

Terminal Value
Enterprise Value
Net Debt
Equity Value

2,982
9,288
12,269
811
11,458

Terminal Value
Long-term growth
Enterprise Value
Present Value
Discount Rate

3.5%
22,428
9,288

10.0%
11.0%

Commentary

D&A reflects amortization of CARs and depreciation of PP&E

Management has guided for NWC to become a source of cash

As Linked contracts phase out, TotalCare becomes a cash inflow
CARs additions rise with the sale of Unlinked engine contracts
Conservative to guidance for capex to fall; maintenance capex rises
The value of cash flow does is heavily weighted towards the back half
of an engine's contractual life. Therefore, it is perfectly reasonable
for the terminal value to be the largest component of value. This
value would be captured if the DCF was extended into future periods

Alternative Terminal Value

Exit Multiple
10.0x
Enterprise Value
24,399
Present Value
10,104

10.0%

Long-Term Growth vs. Discount Rate

9.0%

2025E Terminal

Exit Multiple vs. Discount Rate

3.0%

3.5%

4.0%

13,309
10,753
8,853

14,357
11,458
9,349

15,615
12,281
9,916

9.0%
10.0%
11.0%

9.0x

10.0x

11.0x

12,369
11,322
10,364

13,494
12,355
11,314

14,618
13,388
12,265

19

Civil Aerospace Operating Model

Civil Aerospace Revenue Build
Civil Aero Revenue Build
Wide body engine deliveries
Other engine deliveries
Total engine deliveries
Original Equipment Revenue
Wide body linked revenue
Wide body linked deliveries
Revenue / linked delivery
Wide body unlinked revenue
Wide body unlinked deliveries
Revenue / unlinked delivery
Other OE revenue
Other engine deliveries
Revenue / other delivery
Total Civil OE Revenue
Growth %
Services Revenue
Wide body unlinked revenue
Unlinked wide body install base
Revenue / installed engine
Wide body linked revenue
Linked wide body install base
Revenue / installed engine
Other services revenue
Other install base
Revenue / installed engine

2011

2012

2013

2014

425
309
734

2018
530
278
808

2019
562
251
813

2020
600
226
826

2021
630
203
833

2022
650
183
833

2023
670
164
834

2024

2025

282
471
753

223

267

282

1,766
232
6.87

1,570
208
7.14

1,610
230
7.00

1,575
225
7.00

1,610
230
7.00

1,484
212
7.00

1,400
200
7.00

1,260
180
7.00

1,225
175
7.00

1,190
170
7.00

1,155
165
7.00

1,050
150
7.00

392
79
4.96

504
100
5.04

595
140
4.25

900
200
4.50

1,425
300
4.75

1,750
350
5.00

2,000
400
5.00

2,250
450
5.00

2,375
475
5.00

2,500
500
5.00

2,625
525
5.00

2,750
550
5.00

738

393

471

1,305
431
2.89

1,184
382
2.91

945
344
2.75

851
309
2.75

766
278
2.75

689
251
2.75

620
226
2.75

558
203
2.75

502
183
2.75

452
164
2.75

407
148
2.75

366
133
2.75

3,463
14.1%

3,258
(5.9%)

3,150
(3.3%)

3,326
5.6%

3,801
14.3%

3,923
3.2%

4,020
2.5%

4,068
1.2%

4,102
0.8%

4,142
1.0%

4,187
1.1%

4,166
(0.5%)

0
88

300
188
1.60

230
328
0.70

370
528
0.70

580
828
0.70

825
1,178
0.70

1,105
1,578
0.70

1,420
2,028
0.70

1,752
2,503
0.70

2,102
3,003
0.70

2,470
3,528
0.70

2,855
4,078
0.70

3,035
3.4%

370
344
714

2017

275
393
668

2,934
31.5%

330
382
712

2016

224
738
962

2,232

308
431
739

2015

690
148
838

700
133
833

3,625

3,792

3,974

2,029
4,068
0.50

2,071
4,142
0.50

2,126
4,252
0.50

2,189
4,377
0.50

2,215
4,429
0.50

2,209
4,417
0.50

2,176
4,351
0.50

2,175
4,350
0.50

2,148
4,295
0.50

2,157
4,314
0.50

2,155
4,310
0.50

2,145
4,289
0.50

10,520

10,589

10,535

1,345
10,190
0.13

1,304
9,648
0.14

1,353
9,021
0.15

1,210
8,068
0.15

1,150
7,669
0.15

1,110
7,397
0.15

1,060
7,065
0.15

985
6,568
0.15

919
6,125
0.15

838
5,589
0.15

738
4,919
0.15

657
4,379
0.15

Total Civil Services Revenue

Growth %

3,340

3,503
4.9%

3,620
3.3%

3,374
(6.8%)

3,675
8.9%

3,709
0.9%

3,768
1.6%

3,944
4.7%

4,143
5.0%

4,340
4.8%

4,580
5.5%

4,818
5.2%

5,097
5.8%

5,362
5.2%

5,656
5.5%

Total Civil Aerospace Revenue

Growth %

5,572

6,437
15.5%

6,655
3.4%

6,837
2.7%

6,933
1.4%

6,859
(1.1%)

7,094
3.4%

7,745
9.2%

8,066
4.1%

8,360
3.6%

8,648
3.4%

8,921
3.2%

9,240
3.6%

9,549
3.4%

9,822
2.9%

Note: engine deliveries and engine install base were projected in a separate schedule. Historical engine deliveries were tracked from
1990 to present and engine life was mapped in a waterfall schedule. Engines were conservatively assumes to come offline after 20
years in service. Projected engine deliveries are based on management commentary and guidance.

20

Civil Aerospace Operating Model (cont)

Civil Aerospace Expense Build and Cash Flow Detail
Civil Aero Expense Model
Original Equipment Revenue
Services Revenue
Total Civil Aerospace Revenue
% Growth

2011
2,232
3,340
5,572

2012

2013

2,934
3,503
6,437
15.5%

3,035
3,620
6,655
3.4%

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

3,463
3,374
6,837
2.7%

3,258
3,675
6,933
1.4%

3,150
3,709
6,859
(1.1%)

3,326
3,768
7,094
3.4%

3,801
3,944
7,745
9.2%

3,923
4,143
8,066
4.1%

4,020
4,340
8,360
3.6%

4,068
4,580
8,648
3.4%

4,102
4,818
8,921
3.2%

4,142
5,097
9,240
3.6%

4,187
5,362
9,549
3.4%

4,166
5,656
9,822
2.9%

866
25.0%
1,518
45.0%
709
1,675
24.5%

815
25.0%
1,654
45.0%
942
1,526
22.0%

788
25.0%
1,669
45.0%
1,400
1,057
15.4%

831
25.0%
1,696
45.0%
1,300
1,227
17.3%

950
25.0%
1,775
45.0%
1,200
1,525
19.7%

981
25.0%
1,864
45.0%
1,100
1,745
21.6%

1,005
25.0%
1,953
45.0%
977
1,981
23.7%

1,017
25.0%
2,061
45.0%
1,006
2,072
24.0%

1,026
25.0%
2,168
45.0%
1,036
2,158
24.2%

1,036
25.0%
2,294
45.0%
1,067
2,262
24.5%

1,047
25.0%
2,413
45.0%
1,099
2,361
24.7%

1,042
25.0%
2,545
45.0%
1,132
2,455
25.0%

283

296
4.6%

305
3.0%

314
3.0%

323
3.0%

333
3.0%

343
3.0%

353
3.0%

364
3.0%

375
3.0%

386
3.0%

398
3.0%

461
6.7%

515
7.4%

480
7.0%

482
6.8%

519
6.7%

532
6.6%

543
6.5%

553
6.4%

562
6.3%

573
6.2%

583
6.1%

589
6.0%

82

100

100

100

100

100

93
1.4%

104
1.5%

104
1.5%

104
1.5%

104
1.3%

104
1.3%

104
1.2%

104
1.2%

104
1.2%

104
1.1%

104
1.1%

104
1.1%

942
13.8%

812
11.7%

276
4.0%

435
6.1%

687
8.9%

884
11.0%

1,099
13.1%

1,269
14.7%

1,336
15.0%

1,419
15.4%

1,496
15.7%

1,572
16.0%

344
37
381
5.6%

355
55
410
5.9%

385
65
450
6.6%

468
82
550
7.8%

550
125
675
8.7%

600
172
772
9.6%

650
221
871
10.4%

700
271
971
11.2%

750
318
1,068
12.0%

700
363
1,063
11.5%

600
394
994
10.4%

500
413
913
9.3%

1,323
19.4%

1,222
17.6%

726
10.6%

985
13.9%

1,362
17.6%

1,655
20.5%

1,970
23.6%

2,240
25.9%

2,404
26.9%

2,481
26.9%

2,490
26.1%

2,484
25.3%

748
10.9%

502
7.2%

500
7.3%

500
7.0%

500
6.5%

500
6.2%

500
6.0%

500
5.8%

500
5.6%

500
5.4%

500
5.2%

500
5.1%

86
79
1.09

161
100
1.61

210
140
1.50

280
200
1.40

390
300
1.30

420
350
1.20

440
400
1.10

450
450
1.00

428
475
0.90

400
500
0.80

368
525
0.70

330
550
0.60

TotalCare Net Debtor Balance (Net liability from linked MRO contracts)
TC additions
Linked wide body engine deliveries
TC additions per delivery
TC reductions
TotalCare Net Debtor Cash Flows

1,955
-738
232
3.18
275
-463

2,211
-672
208
3.23
268
-404

2,344
-575
230
2.50
442
-133

2,415
-540
225
2.40
469
-71

2,461
-529
230
2.30
483
-46

2,435
-466
212
2.20
492
26

2,368
-420
200
2.10
487
67

2,255
-360
180
2.00
474
114

2,136
-333
175
1.90
451
118

2,015
-306
170
1.80
427
121

1,892
-281
165
1.70
403
122

1,754
-240
150
1.60
378
138

Segment Change in Working Capital

% of Segment Sales (Guided to be a future source of cash)

436
6.4%

484
7.0%

412
6.0%

355
5.0%

310
4.0%

242
3.0%

167
2.0%

86
1.0%

0
0.0%

-46
(0.5%)

-95
(1.0%)

-147
(1.5%)

OE Gross Profit
OE Gross Margin (Standard costing)
Services Gross Profit
Services Gross Margin (Standard costing)
Cost of Goods Fixed Costs
Gross Profit
Gross Margin
Administrative Costs
% Growth
Research & Development
% of Segment Sales
Restructuring Costs
JV Income
% of Segment Sales
EBIT
Operating Margin
Asset Depreciation and Other Amortization
Amortization of CARs (Additions amortized straight line over 10 years)
Total D&A
% of Segment Sales
EBITDA
EBITDA Margin

Cash Flow Detail

Segment Capital Expenditures (Management guided capex to fall)
% of sales
CARs Additions (Capitalized Asset Recoveries; unlinked engines losses)
Unlinked wide body engine deliveries
CARs additions per delivery

21

Thank You!

DISCLAIMER: THIS PRESENTATION IS NOT A RECOMMENDATION TO BUY OR SELL SECURITIES. PLEASE DO YOUR OWN RESEARCH.
EVERYTHING PRESENTED CONSISTS OF MY OWN OPINIONS AND DOES NOT REPRESENT ANY CURRENT OR FORMER EMPLOYERS.