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.