Engine trouble

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Neil Woodford 9 December 2015 Est. reading: 3 min read

Home > Words > Blog > Engine trouble

Rolls-Royce has been an ever present holding in the CF Woodford Equity Income Fund and the Woodford Patient Capital Trust since their respective launches. In fact, I have held it in other mandates for almost ten years.

Over the last couple of years, Rolls-Royce has become a more challenged business and this has weighed significantly on its share price. Some of these problems represented growing pains, as the business transitions between civil aerospace engine designs and invests in new capacity to deliver its substantial forward order book. The business has also suffered from the deteriorating global economic environment, particularly in its marine business which has been negatively impacted by the slump in oil industry exploration activity.

Along the way, many investors have become frustrated with the company’s inability to manage expectations effectively. Although we have shared this frustration to an extent, we have previously taken share price weakness as an opportunity to add to the holding, believing that the dip in profits and cash flows would be relatively short-lived. We were also confident that the company’s world-class civil aerospace engine technology and the £80bn order book would ultimately deliver very significant profits and cash flows beyond 2017.

November’s very disappointing trading update has changed this view, however. The problems, which initially had affected the military aerospace and marine businesses, now appear to have spread to the core civil aerospace business. This has resulted in material downgrades to profit and cash expectations, and to such an extent that it is now likely that the dividend will be cut in 2016. This has shaken my confidence in the investment case and so the position has been sold across all mandates.

So what has changed? Primarily, in summary, it is my long-term confidence in the business model. Rolls-Royce civil aerospace engine business is pretty opaque and difficult to analyse. It is characterised by significant new business strain in the form of losses (usually accounting but always cash) on engine deliveries, which are then recouped over many years of operation by airline customers paying TotalCare service revenues. This is a very long-term business which is sensitive to assumptions around manufacturing and servicing costs and operational metrics such as the number of hours flown, reliability and operational longevity.

Our decision to sell the shares reflects a significantly increased level of uncertainty about how these metrics will play out over the next 3 to 5 years in a way which will benefit Rolls’ shareholders. In many ways we hope we are wrong, but we think it is in our investors’ best interests to exercise caution at this point in time. However, we plan to stay in close contact with the company in order that we can monitor progress under the new leadership team which we rate highly.

If our caution is misplaced, we will look to invest again in the business but for the time being we are happy to stand on the side-lines. Of course, our decision to sell also reflects the intense competition for capital in the portfolios. Accordingly, we have deployed the proceeds of the sale of Rolls-Royce shares into a number of other positions in the portfolios where we have more confidence that they will meet our 3-5 year high single-digit annualised return expectation.

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  1. The business hasn’t really changed just the execution, so I guess I find it difficult to see why the long term view has changed, unless we weren’t really sure what we were buying in the first place. I guess its surprising to read that Neil thinks its difficult to analyse the civil part of the business, Neil describes the business models issues, but we knew that before didn’t we? Should we invest in what we cant analyse?

    1. I guess the sale makes a bit more room for more biotech?

  2. Interesting. Thank you for the explanation. I’ve held RR for many years, ups and downs. The company’s exit some years back from narrow-bodied commercials bothered me a bit, as it seemed to be ceding a strategically important field to our American friends. Maybe there wasn’t the capital to do everything well but, if so, why not excel at aero engines and exit marine. So, I hoped (and still do) that the underlying product excellence would outweigh the possible management aberration. Your decision to sell RR reinforces the reasons for private investors to buy funds, not just individual shares. Choose experts and leave them to do their thing. I expect to hold RR through this current slough; but no one is measuring my performance…

  3. Raj….I think your comment is spot on.Rolls Royce business has not changed.Neil has changed his view.Its always been difficult to analyse and it’s always been opaque.Sounds like he may have called the bottom!

    1. I am a bit surprised to learn that Woodford Fund admitted that it is hard to analyse Rolls Royce’s opaque business but the burning question is why they bought the Rolls Royce share in the first place?

      1. Manoz, I suppose the same could be said about Drax or the AA or Babcock for that matter.

        In the case of Drax, it’s been falling since the fund launch with a decimated profit opportunity due to the increased carbon levies which rise above inflation each year. I’m not sure anybody believes that shipping wood pellets from America, storing them in huge silos and burning them in expensively government subsidised biomass units can be classed as environmentally beneficial, let alone has an economic argument. All of these factors have been known from the get go. I guess the only possible saving grace is that UK government hasn’t a clue what it’s doing with our energy policy, the lights will go out and they have to go cap in hand to Drax and pay a high price. Apart from that last point, it’s a puzzler.

        The AA was floated from the private equity boys after receiving what is a mountain of debt. The investment case seemed odd given that the size of it’s debt almost made the business incidental. That has been borne out as the share price has collapsed.

        Babcock on the surface looks OK being aligned with Nuclear (which personally I believe is a huge waste of tax payers money) but what’s concerning is Babcock’s aggressive accounting policies which could be exposed down the line, similar (although possibly not as bad) as Serco.

        Investment is a very difficult business and looking at Neil’s excellent track record, he does a better job than most, but some of the investments seems unfathamoble to me.
        Selling Centrica and SSE at low points seems odd also. Then again I’m not a fund manager.

        LR

  4. Good article.
    I purchased Rolls Royce a year or so on my stock brokers recommendation. I studied engineering at university and liked the science element of the business, so followed their advice, which is what I pay them for. Many years ago I read about a trailing stop loss strategy which I loosely follow and as always with hindsight should have used it more aggressively. Accordingly I sold my Rolls Royce at 672p a month or so ago, taking a loss (I never like taking a loss), but just before the recent profit warning and further share price fall.

    I like to invest in companies when their spare price is depressed and wait for the recovery, rather than sell when a share price is low which is what I did with Rolls Royce. Accordingly I was considering reinvesting now that the share price is 100p or so lower than where I sold, but your article has reminded me that there are other business that have better capital growth and income prospects, so I will stick to my view.

    As an aside, I recently purchased some of your fund for my wife’s ISA. Keep up the good work.

  5. This all comes down to their maintenance philosophy. By only allowing flat rate overhauls from RR and limiting 3rd party repair stations they have removed the residual value of the engine.

    They are now engines you run until they are done and exchange as opposed to being fungable assets which have a value after their first shop visit.

    The lessors/operators don’t like that and prefer the flexibility they find in V2500, GE engines, and CFM engines.

    RR will be out of the industry soon.

    1. I do agree with some extent with you. However this is clear for an airline from the beginning. So you buy an RR engine which is cheaper but you are looked into a long servicing contract or you buy a GE engine which is more expensive but you have a re-sale value.

      I believe there are two issues here:

      1. cost, RR really needs to reduce costs;

      2. wrong focus on bigger engines for Airbus A380, Boeing 777 and 787, when the regional market for smaller planes is growing faster and RR does not have an engine for this market. This one hurts badly.

      I am not sure RR will be out of the industry soon as you predicted – one thing I learned is not to make predictions. However it needs to restructure their business.

  6. I am reminded of 1971 when RR got into trouble. This is a bold move and what we pay Neil for!

    “History, with all her volumes vast, hath but one page” (Byron)

    1. Neil is the only fund manager I have who explaines the reasoning behind his decisions to buy and sell holdings regularly to the investors, I have been impressed with the resilliance of his income fund during the past turbulent months ,something he has always always excelled at in troubled times.

      1. Totally agree with your comment

  7. This seems a puzzling and marginal decision based on a motivation of avoiding short term uncertainty. Given the fund’s viewpoint of seeking investments that can control their own destiny in a low growth world, RR should still fit the bill – a strong growth civil aerospace market, bulging order book, highly rated management with the ability to turnaround short term difficulties, and with high barriers to entry providing a broad moat.

    It would be interesting to know whether the decision was made before or after the briefing on 24th November.

    1. “highly rated management”

      This is the difficult bit. I suspect this is more a comment in the article designed not to offend or burn bridges, as the previous CEO was not deemed a good communicator with city or internally. The new CEO has only an electronic engineering background at Texas Instruments and ARM. There maybe parallels, but there are also significant differences between high technology high volume integrated circuit design (with outsourced manufacturing to TSMC) and a heavy engineering company with complex and multifaceted “in-house” manufacturing spread around the globe.

      No — there are no slam dunk certainties about the management — it’s a risk.

      LR

  8. Did you understand the business when you invested in it?

  9. perhaps more of the blame for the downfall of RR should be placed on the management structure and personnel.

  10. Investing in the income fund was my first experience of the stock market, and I feel I’ve learned such a lot from these commentaries, and the ensuing discussions. I really appreciate the transparency and the opportunity for people to ask questions.
    I do feel that on occasions, some investor contributions may step over the boundary between constructive challenge to the team and being slightly offensive (however unintentionally). I’m sure Neil’s shoulders are broader than mine, but nevertheless I’m a bit concerned that there’s little incentive for the team to provide transparency when things go wrong, (as inevitably they will occasionally) if we respond to it churlishly.
    Re Rolls Royce, I’m disappointed that things haven’t worked out with Rolls Royce as it’s such an iconic brand, but totally respect the decision.

    1. A very sensible response. In my experience you will do better than the average investor as you clearly can take a balanced approach something sadly lacking in our blame culture.

  11. I guess it makes more room for biotech shares

  12. Can someone from Woodford please explain why the Patient Trust has fallen recently from over £1.20 to just below par ., and what the future holds for this account.

    1. Anthony, This one requires patience. I guess there is a hint there in the title. Some of these investments are very high risk and rely on winning key patents and drug approvals. Some will fail, but provided a goodly number are hits the fund will do well in 5-10 years. It doesn’t really matter if the fund falls another 10-20% provided the underlying companies stay liquid and eventually deliver.
      There is some income support in the fund as it has a smattering of blue chip income generators.

      Sorry I’m not from Woodford, but it’s (I think) a reasonable observation.

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