Wednesday, January 28, 2015

Ninth Pick in the WMD Portfolio - Rolls-Royce Holdings

The more real they are, the more fun blogs are to follow. So in that spirit, rather than talking about ideas in the abstract I maintain a hypothetical portfolio to track ideas where I'll semi-regularly (and hypothetically) invest and track buying (and where required selling) shares.

For tracking purposes I will use $1,000 to keep it nice and simple. The overall goal is long run income and dividend growth. Portfolio page with goals and tracking is here.

I tend to like the economics of duopolies - Coke/Pepsi, Visa/MC, Fedex/UPS, Boeing/Airbus. Pricing tends to be pretty rational in these markets. The main suppliers of wide body jet engines  are General Electric and Rolls-Royce. GE is a fairly interesting business at these prices and it pays a solid 3.7% yield. Potentially more interesting is a main supplier for jet engines - Precision Castparts. The fundamentals of PCP are very attractive, however since they are focused on rolling up the supply chain the company prioritizes acquisitions not dividends so that rules it out for the WMD portfolio.

The other half of the duopoly - Rolls-Royce is a company whose investment profile ticks the main boxes for the Wide Moat Dividend portfolio. Rolls-Royce engines are used in the most advanced wide body aircraft today including Airbus A380, Boeing 777, and Boeing 787 Dreamliner. Think its easy to compete on jumbo jet engines? This BBC documentary shows exactly what goes in to building these engines. 

Civil and Military Aerospace account for over 50% of Rolls-Royce revenue. The rest is comprised of Power systems, Marine and Energy.

Rolls-Royce pays a 2.7% dividend which is a healthy premium to the yield on the S&P 500. The company has grown its dividend every year since 2010. Rolls-Royce can easily afford to continue raising its dividend, its payout ratio sits at 18%. 

Its a cyclical business. In the post crisis years the ROE has ranged from 14% (2010) on the low side to 43% (2012) on the high side. In my view the recent lows are not too bad and the good years are very good. The Debt/Equity ratio is 0.3.

Neil Woodford is a fan and has Rolls-Royce as one of the largest holdings in his portfolio.

Unlike most of the market today, Rolls-Royce is a relative bargain which sells at near 2008-09 lows. The current P/E is 7.4 and the P/CF is 8.7. To me this looks like a quality company at a discount price.

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