Rolls Royce (RR.L)

Sells “power-systems” (read engines) for air, land and sea. The business model is to sell engines at break even prices but then have long term service contracts (called TotalCare) to provide stable cash flows to the company.

Rolls-Royce (2013-2014)

The management needs to concentrate on two things : (1) growing the installed base, and (2) cost control.

The cost control is imperative to the business viability. Here is why.

The TotalCare contract works as follows. The customer buys an engine and then signs a TotalCare contract which is going to cover the “maintenance” aspects. If the engine breaks somewhere, Rolls-Royce is responsible for fixing it. Even when it needs to be flown. In return, Rolls-Royce gets paid by the hours-flown at a pre-arranged price. So, if Rolls-Royce makes awesome engines which need very little maintenance — all this is profit. On the other hand, if they do not control costs or make crappy engines then they may end up losing a lot.┬áNotice the similarity with the insurance business. If Rolls-Royce prices TotalCare badly, they end up losing a lot of money. They also lose a lot of money if there are unexpected issues (systematic problems in all engines for example).

The business model is a win-win for all concerned. Rolls-Royce is incentivized to design good engines and train pilots to use them correctly. It is also incentivized to make them more fuel-efficient. The customer gets better price for the engine if it managed by TotalCare.

[TotalCare Accounting]

Let us get to the valuation. The company has a net cash position on the balance sheet (around 600M pound). The company is growing around 10% and for a good business like this, I am willing to pay 15 times earnings. The “normal” earning power seems to be around 1B … so I am a buyer below 15B. Currently, at 670 GBP, it is selling for 12B.