Rolls-Royce: Turbines and Tribulations - [Business Breakdowns, REPLAY]
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Welcome back to Business Breakdowns. Today, we are covering Rolls-Royce. A fair warning to those expecting to hear about luxury automobiles, that division was split from this business in the 1970s. But as we discuss the history of Rolls-Royce on this episode, you will hear how the DNA of this company still ties together from its early 1900s origins.

Our guest is Graham Forster from Orbis Investments. Graham walks us through the core business of Rolls-Royce in the aerospace market, the evolving duopoly of the wide-body aircraft engine manufacturers, and the ups and downs of properly capturing the economic opportunity. We've talked about other duopolies in the aerospace market, Heiko, Transdime come to mind. The performance here has been different.

particularly over the long term. You've seen more ups and downs. And I really appreciated Graham's intellectual honesty discussing roles. And I expect you will, too. Now on to the episode.

All right, Graham, I am excited to have you here to talk Rolls-Royce. I think this is a brand that pretty much everyone is familiar with, but the business that is a publicly traded entity might be a little different than the Rolls-Royce that many people think of. So I thought we could just start there with a simple overview of Rolls-Royce Holdings, the publicly traded entity. What is that business today? Thanks.

Thanks, Matt. Given this is a British business, one of the few remaining high-quality global British businesses, it's nice to have a Brit. So thank you for inviting me on today. Amen.

At its core, the way I think about it is as a power business, so mainly converting stored energy into kinetic energy, right? Would be the fancy way of saying they make big engines effectively, such as airplane engines and the like. This core goes way back to their roots in the early 1900s. And that started with early motor engines. The thing that people know about Rolls-Royce motor, the cars, they actually don't do that anymore.

but they still have that consistent DNA that they have had for the last 120 years. I would characterize the culture as one of engineering excellence. So they try to do a few things, do them exceptionally well. Henry Royce, one of the co-founders with Charles Rawls, was quoted as saying, whatever is rightly done, however humble is noble.

That philosophy, I think, has really stood the test of time. The crown jewel in the non-car Rolls-Royce, the one we're here to talk about today, is really the civil aerospace business. That's engines for large commercial planes, as well as business jets. They also make a bunch of other powertrains, so marine trains, industrial machinery, nuclear, including military, such as nuclear subs for the British Navy.

And they have some energy generation and storage as well, which is benefiting from increased need for power through electrification and data centers and the like. That's what they are. That's what they do now.

And they've also got some great opportunities to develop new business lines going forward in very, very meaningful markets. One being using their expertise in nuclear, they're pushing into small modular reactors, so-called SMRs, which could play a meaningful role in the nuclear renaissance, which I think we're quite likely to see over the next few decades. You mentioned the auto business, and it's my understanding that, as you mentioned, they were

once together as part of one single business. What led to that spinoff or that separation and then concentrating on the core markets that they're focused on today? You can go way back.

The company was founded in 1906 by Charles Rolls, Henry Royce. They were very, very different people, very different backgrounds, but they were really linked by that passion for engineering, passion for motor vehicles at the time, which were really just getting going. Ford's Model T hit the market in 1908, so a couple of years after Rolls, Royce was founded. Charles Rolls, Henry Royce were both fascinating characters. Rolls was from the money class, studied engineering at Cambridge.

was a passionate race driver. He was actually the second Brit to obtain a pilot's license, and he was the first to fly across the Channel and back. So super adventurous, also very entrepreneurial. He built a business importing French cars to sell in the UK, but he ultimately wanted to partner with a British carmaker, which is how he came across Henry Royce.

Royce's family were very, very different, very much working class. His father actually died in the poorhouse when Henry was young and that shaped his character. If you don't know what the poorhouse is, think sort of Charles Dickens sort of novels.

Henry Royce, he carried a lot of grit, a lot of drive, and he became an exceptional engineer, both mechanical and electrical. He had a completely obsessive personality by all accounts. He was obsessed mainly with quality. He reminds me a little bit of an early Steve Jobs in some ways. He was maniacal around delivering the best product, essentially.

So the two got together with Royce looking after the engineering side and Rolls looking after the business side. Sounds like it started with the automobile business. How soon thereafter did they start extending into aerospace and other fields of industrial engines? The initial core of the business was cars. That's what we think of when we think of Rolls-Royce. It was World War I, so 1914, when Royce

became obsessed with building aircraft engines effectively to help the war effort. That was the birth of really Rolls-Royce Aerospace and the Defense Division put together. Then in World War II, the company was one of the first to build the first jet engine, so gas turbines, which generated their own thrust rather than using pistons to turn a propeller, a little bit similar technology to in the cars. Incidentally, at that time in the Second World War, they shared their

engine designs with the US, their jet engine designs. And that went to GE, which has been competing with Rolls-Royce ever since. Those two companies are really the dominant force in large-scale engines today. So the move into aerospace engines

was very fruitful for the company. It brought enormous reward, but also enormous risk. These are highly complex, high value and low volume engineering feats. So if you get it right, then they should be highly profitable. But if something goes wrong, it can put the whole company in peril. And that's effectively what happened in the late 60s and the early 70s with the RB211 engine.

That project was hugely mismanaged, massive cost overruns, and pretty weak engine performance, or at least weaker than predicted. And this led to a nationalization, effectively. Rolls-Royce was still a key British asset with links to national defense, so they couldn't let it go. But as part of that nationalization, the car business, the original piece of that business was spun out, and that was sold off as Rolls-Royce Motors.

And then Rolls-Royce PLC, the large engine business that we're here to talk about today. So Rolls-Royce cars now sits actually within the BMW group. And that's a valuable and somewhat underappreciated asset, in my opinion, within BMW.

And it's a bit of a tangled web of a story as to how it got there, but it's very much a separate entity today. Thinking about the connective tissue between those two businesses, when I think about the auto manufacturing, it is the engine, which is such a major part of it, but it's also all of the finishes and the touches on the actual car itself, which bring it to an entirely different level of prestige, right?

Comparing it to the aircraft engines, which I assume they are just doing the engines and nothing more. Is it safe to say that everything that revolves around the brand and the expertise and the focus was really that engine? That prestigious touch in terms of the automobiles is something completely separate from what I'm thinking about here. The culture, I think, is the connective tissue. And the culture was put for perfection.

There were stories when, from the early days, if you bought a Rolls-Royce in 1910 or whatever, it was the most reliable engine. It was the most reliable car ever.

That came from the obsession around the quality and how everything comes together in this sort of perfect way. That is the connective tissue between Rolls-Royce PLC today, which isn't designing a holistic, beautiful vehicle. It's still a very high value, low volume operation. The focus on quality has to be enormous because the risk of getting it wrong is just as high.

I don't know what the culture is like within the Rolls-Royce division sitting inside BMW, given the success of that motor business, especially over the last 20, 30 years, and the longevity of that brand. It's clear that they have the same obsession with quality across those two businesses.

You said it well in terms of the culture and the importance of that perfection. And they were just doing perhaps a little bit more and needed to perfect that than what's happening on the engine side of things. Bringing it back to the business today, you outlined that commercial engine business, the genitive business being the crown jewel. What does that actually look like in numerical terms, just in terms of the various segments that you touched on before? You can cut it a few ways, but I would say there's

four main value drivers within Rolls-Royce today. The key one that people think about, people talk about is civil aerospace. That's 50% of their revenue. That's the large engines for wide body planes. It's big twin aisle passenger planes. You think long haul, it could be freight, of course. So just the big planes, they make those large engines for. And within that division, they also make small engines for business jets, which is also a very good business. So that's

50% of the revenue. The other 50% is split between power systems. Power systems are effectively large off-highway engines as well.

So you think about it, Rolls-Royce motor isn't sitting in there. That would be the highway piece that was taken out. They still got a lot of off-highway business. That's marine, big boats, industrial, trains, et cetera. And then within that business, they have energy production and storage. Think large scale turbines, same technology, large gas turbines to produce electricity and power.

very similar to the technology of a big jet passenger plane engine. They have generators, backup generators, battery storage, benefiting again from that boom in data centers. And the third, those power systems would be 25%, and the other piece would be defense, which again, making very similar things, but focused on air, land, and sea applications. And the most interesting piece of that is probably the nuclear sub program.

where they make the power drive for submarines, if you're thinking about a submarine.

What's the advantage? It's being able to submerge yourself for long periods of time. If you're running a gas propeller within the sub, you have to come up and get rid of all the waste gases that you're producing. With a nuclear sub, you can stay submerged for as long as you like. These things can power themselves for months and months and months on end. They have a really good business in there. And then that's the springboard for the fourth value driver, which would be new markets. I mentioned SMRs.

come from their expertise in nuclear through the submarine program. And that can extend way into the future. I think in terms of these small modular reactors are effectively a piecemeal way to build a nuclear facility. But as the technology gets better, you can

You can imagine you get micro reactors, so reactors sitting within small boxes that effectively could be used in remote locations and in space applications. Thinking 30, 40, 50 years into the future, how are you going to bring power to the moon? If you're Elon Musk, how are you going to bring power to Mars? Micro reactors are one of the ways you could do that. On the advantage that they have in terms of producing these engines for multiple different industries, there's obviously overlap in terms of

what's happening. But can you talk about how they maintain that advantage relative to new entrants or peers? What the key measurements are, whether it's engineering productivity, efficiency of these engines, anything that you can touch on just in terms of what makes these so special and give them the market positioning that they have today? They tend to have very strong market positions, especially in the bigger engines.

The way I think about it is they tend to make very high value, low volume things in which scale and share is really crucial for any cross cycle profitability. So in large aerospace engines, for example, they only make 300 a year and they've got a 50% share of new orders in those wide body planes and 30 to 40% share of the installed base, which is critical. And that's growing obviously with the share in new orders.

I think it's quite telling that the early leaders, so think General Electric, that example in the Second World War where they got jet engine technology for the first time, and Rolls-Royce, and one or two others are still around after many, many decades. It's a super stable industry.

It's got good competition, but also attractive economics if you can execute well. The structure of the market is a function of the fact that what they do is so difficult, so low volume, you need a lot of scale. So if you're the company that has the engineering ability to get those engines out first, you should be able to maintain that advantage over time. Other markets they have are quite similar to that. As you go down into power systems, you're making these big engines for boats and industrial equipment.

Not quite as high market share, but a very similar dynamic. Maybe we can talk through these relationships that they have, just in the sense of how the engines are sold to the airlines, what that looks like if they're being developed alongside a new aircraft program, some description of how they're recognizing revenue and what that's actually like when you have such a small amount of volume being sold into the market. There's usually unique dynamics that are driving it.

When they are developing these engines, they're usually developing with the airframe, with Boeing, with Airbus, typically. What they're trying to do is build a product that will sell, so they're optimizing with the engine as part of the whole. The way that the ecosystem works is...

In working with, let's say, Airbus on a new plane, they will optimize for what they need to optimize for. And then the sale of the engine will be to the airframer. So they'll be selling the original equipment to Airbus effectively. That's roughly one third of the revenue for the engine, but it will be a much lower portion of the profit.

So they're actually selling the engine to Airbus at a reasonably low margin. And then what they'll do is they'll

come to an agreement with the underlying customer. And there are many, many more underlying customers than just the airframers where there's only two. And those would be the airlines. So the airlines, when they purchase the planes from Airbus, they'll come to an agreement, an aftermarket agreement, which is called a long-term service agreement with Rolls-Royce to service that engine over its life. So that's where, I mean,

The majority of the margin is made for Rolls-Royce, and that's the dynamic in terms of the sale. What is the life cycle for an aircraft engine? It varies.

Typically, it depends on the success of the overall program, but it could be up to 30 to 40 years for a single engine. The service agreements themselves are struck over maybe a 10 to 13 year timeframe, so they're quite long dated as well. Is there ever a situation where they would lose the service agreement upon a renewal if the Rolls-Royce engine was still in place? Very unlikely. Yeah.

Once you're working with a customer with those service agreements in place, you're the one with all the infrastructure to do the maintenance, with all the infrastructure to look after that engine over its life in the most efficient way possible. And you're the one with all the data. So they're increasingly doing a lot more work with software to try to get all the data on all the components in real time. The service agreements with the airlines are very sticky. What typically happens is if nothing changes over the life of a contract,

the airline will just have that service agreement over that period. And then at the end, there'll be a renewal and a negotiation on that renewal. If the airline changes anything,

So for example, if the airlines are consolidating all the time, so if there's a merger, that might trigger another renegotiation. One long-term service agreement, one LTSA could cover 20, 30, 40 planes in a fleet. If they want to add planes to that or take planes out, then that might trigger a negotiation. So you get these points along the way within those 10, 12, 13 years where you'll kind of strike new terms.

A 30-year life of an engine was much longer than I expected to hear. I know with many aircraft parts, there's a lot of replacement that happens through the life cycle of the actual aircraft. Is it common to see engines replaced? It's common to see a lot of the components changed. All of the components of the engines will be changed over time or more or less. Every five years, four or five years, the engine will go through a full service overhaul, which means the

Plane is grounded, the engine's taken off, it's brought into Rolls-Royce's facility, it's done a full strip down, full service, put back together, back on the wing, and off you go again. A little bit like any big bit of kit, over time you're replacing a lot of different bits. So the age of the engine becomes a bit of a subjective thing because you've got so many new components on there. For me, the model is interesting in the sense that you can almost compare it to...

writing insurance. So Rolls-Royce gets paid a premium on these long-term service agreements. And the way that they're paid is on hours flown. So if Lufthansa has its airplane in the sky flying for every hour it's up there, Rolls-Royce is getting a dollar amount. That's effectively getting, if you think of it in insurance terms,

Made a premium to ensure the engines stay operational, to ensure those engines are serviced. And if anything goes wrong, Rolls-Royce will fix it. And it's interesting, if you study the insurance industry and you strip back all the layers that typically take a margin along the value chain, you notice just how profitable insurance is. It's a hugely profitable industry. And usually you just see a piece of it. You see an insurance company, then you've got to look at the broker, you've got to look at another layer, another layer.

And across that value chain, there's a lot of profit. Why is insurance so profitable? It's because individuals or businesses can easily be swamped by costly tail events. So it's just super valuable. It's needed, and therefore it should be priced as such. And it is priced as such, which is why there's so much profit in the system. In that regard, given Rolls-Royce is doing something similar,

It's essentially direct insurance, so you don't have all the layers here. It's just Rolls-Royce dealing with its customer direct. These long-term service agreements, they should be really very good business through the cycle. I think historically, they haven't been for Rolls, and that's an interesting dynamic, but they're doing a lot today to make sure that that becomes how it should be. GE, for example, have quite similar dynamics.

And they've made a lot more of that structure in terms of their margin through time. In the insurance example, the tail event or the put that would come back to Rolls-Royce would be there is some type of issue with the engine or some parts, and they are replacing that at no additional cost to the customer due to that maintenance contract. Is that right? Exactly. Whatever's in that service contract is

It's changing a little bit now, but historically, these contracts were very bespoke to different airlines and they'd be very, very long and detailed and have a lot of conditions in them. But essentially, it would cover the scheduled overhauls. It would cover various changes in parts which were scheduled outside of those overhauls. And it would cover the tail event. So if an engine went wrong, it all sits with Rolls-Royce.

It'll have things like caps in there and whatnot, but it would sit with Rolls-Royce. And therefore, the risk transfer to Rolls-Royce is enormous. These are such big programs. They spend billions developing the engines, and it's a huge part of their business. That was the reason why the bankruptcy happened in the late 60s and the early 70s. More recently, they've had a lot of problems with their Trent 1000 engine, for example. The incentive to get these engines right in terms of the engineering, the manufacturing,

The maintenance is enormous because of the way these contracts are written. Not to pound the insurance analogy into oblivion here, but you mentioned that these contracts should be profitable.

Similar to insurance, it can be a great business, but it's not that easy to underwrite insurance due to various things. It could be geography, it could be how you're pricing it. There's a lot of different things which make insurance not the simplest business. Those that do it well do it incredibly well. When you think about those different components here with the contracts, whether it's the tail event, whether it's routine maintenance, whether it's component replacement...

Is there something specific there that has been driving the lack of profitability or lack of maximizing potential there? You could say it's just your pricing. Your assessment of the risk should go into it.

the pricing itself. Now, in the past, I think Rolls-Royce have fallen over both on the pricing and on their own cost discipline after the pricing is set. When it comes to pricing, it's just really about getting the value that you should be getting given the service you're providing. I mean, the service they're providing is extraordinary. If they can keep those airplanes in the sky,

flying around for their customers, then the airlines are super happy. That's their whole business and that's what they want. And if they can minimize the time when they're doing the overhauls and do that as efficiently as possible and then get the plane back in the air, that's hugely valuable for customers. They should be paid for the value that they bring historically because I think of their culture going right back to the early days, 1906, with Henry Royce

Their culture is on engineering quality and engineering excellence and not so much on the commercial side. I do wonder sometimes if you go way back to those early days, it was Charles Rolls who was running the business side. Tragically, he died only 32 years old, six years after the business started in an air show. He was doing all sort of air stunts in what I think it was one of the Wright Brothers planes.

Something went wrong with it. And then, of course, there were lots of other people in the business thinking about the commercial side, but it really became Henry Royce's show. And so he drove the culture of that business and it was all about the engineering. And that's a wonderful thing. That's how they got them to where they are today in terms of that position in the industry and the great products they make. But they've never really had that culture on the commercial side.

to drive the value that they deserve for the product that they're building. Whereas if you look at a GE in the US, a bit more commercially minded, they've managed to generate more profit and more margin from that business, both on the cost side and on the revenue side. Under new management that they have now, that's the direction they're aiming to go. But I would say that pricing that insurance is absolutely critical.

Is that insurance dynamic similar across all of the other segments of the business? Is there anything materially different about those segments versus the aircraft business? Aircraft business isn't unique, but it's on one bookend. So if you think of the bookend between the actual generating profit on sale versus the profit in the aftermarket, the civil aerospace business sits on one end in terms of generating more than those other businesses in the aftermarket.

You can run through power systems as reasonable amount of aftermarket revenue, but it's not as extreme. Somewhere in the middle in terms of generating profit on the original sale and in the aftermarket. And then if you get to defense, typically defense tends to be more of a volume business in terms of the sales they make. Of course, there's a service element there as well. I think that would be the spectrum.

There's a trade-off from a margin perspective. You can operate with lower margin and offset that with higher volume. So gross profit is still growing. Is there any underlying data to suggest that there's market share gains which are offsetting any of those lower profitability dynamics happening on the MRO side? There's always that dynamic of, can you drive volume through market share? There is always a trade-off there.

It's absolutely true. But I think when it comes to a market where you've got a duopoly in wide body like you have today between Rolls-Royce and GE, there just is a level at which the market as a whole, i.e. all the customers want to see at least two thriving businesses in there with some level of price competition between them. Once you get to that type of market,

I think it swings a little bit more towards optimizing your margin than optimizing for share. That is something that Rolls-Royce hasn't got right in the past and is increasingly trying to do that going forward.

The aerospace business is a fascinating ecosystem in terms of where the value capture happens. You have duopolies in certain spots, and then you have the airlines, which have historically not seen nearly as much value capture, while a lot of the suppliers have at least found a way to balance and create those well-managed duopolies. I'm curious on the customer front, if Airbus or Boeing are releasing a new model aircraft,

Are they selecting one engine provider? Do they ever mix and have a certain amount of the aircraft with a GE engine and the other percentage of the aircraft with Rolls-Royce engines? The airframe makers are increasingly selecting for one provider, especially on wide body where the volumes are lower, less scale. So the A350, for example, is exclusively using Rolls-Royce XWB engine.

The 330 Neo is exclusively on the Trent 7000. I think there are pros and cons of single sourcing. There's obvious

ways that that falls over. But the big plus is scale, which lowers cost. Plus you can optimize the aircraft holistically, and that's increasingly becoming more and more important. If you can work with an airframe early on, on a specific new design and optimize both the engine and the airframe together for performance, that can lead to it.

very, very meaningful efficiency gains just because the engine is such an important piece of the whole. If you've got two engines on it, then you're basically bolting on a slightly different engine onto an airframe and you can't run that holistic optimization as well. We've talked a little bit about the margin profile at a high level. Can you put some numbers on the business just in terms of whether it's by segment or however you would lay it out, what the margins actually look like?

They all sit in the high single digit for the very low end to, I would say, mid-teen margins across all of their businesses. And I would argue that the efficiency of the whole of Rolls-Royce is below where it should be. There's probably a few divisions in there that are reasonably efficient and operating at their kind of margin capacity.

You can take bits of power systems and compare them to something like a Caterpillar, or you could take Rolls-Royce's civil aerospace business and compare it to GE Aviation, which is now standalone. There are big margin differences between those. So in the civil aerospace, which is probably the most important in terms of profit going forward and profit improvement going forward, it's sitting low teen operating margins. And they think, and we think they can get to high teen

over the next five or six years through all of the things that they're doing to optimize on the revenue side and on the cost side. Where's GE out of curiosity? It's in the low 20s. Big difference. And when we originally invested in 2015, it was on that view that there's so much fat that could be cut in this business just because of that meaningful difference.

Part of GE's margin is because they've got more scale through the narrow body business. They just produce more engines, albeit smaller ones through narrow body segment. But I don't think that accounts for anywhere near the difference with Rolls-Royce today.

We've alluded to the pricing of what they're doing. You mentioned cutting the fat. Is it excess labor costs? Obviously, there's geographical dynamics in terms of where you operate and the costs associated with that. But is there anything else that stands out where this is a line item where it is just massively mismatched versus either competition or what you think should be reality? So when new management came in, this was a couple of years back. There have been a few management teams over the years that had really

tough period after GFC or not long after GFC and that was where Trent 1000 started going wrong on the Boeing planes and

and really their first meaningful engine blow up since the early 70s, always having little issues, but this was a meaningful problem they had with the blades wearing out too soon on the engines. There was a change of management then, and they brought in the CEO, Warren East, and he was already on the board of Rolls-Royce. He came in knowing that changes needed to be made, and he was gradually making those changes, let's say from 2014, 15 on. Then COVID hit,

That caused incredible disruption for this business. Most businesses, when they go through a downturn, they lose their earnings or earnings might go negative. They don't lose their revenue. Rolls-Royce lost their revenue because their revenue is based on flying hours and all the planes in the world more or less were grounded. And so they lost their revenue stream, an extraordinary period. That was a little bit of a double-edged sword.

for roles because on the one hand, it was an absolute disaster and they needed to raise a whole bunch of capital to survive. On the other hand, turning around a business that is underperforming to the degree it was underperforming in terms of the margin profile is hard and Warren East was finding it very difficult because there are unions, because if you're going to a customer and saying, look,

The margin profile on these long-term service agreements is just not sustainable for us. What does the customer do? They're not going to just say, okay, it's very difficult to come to different terms with customers. It's very difficult to change your cost structure in normal times.

And what the crisis did is it gave Warren and the new CEO came in in 2022, Tufan. He came in from BP as more of a turnaround expert. Warren did a good job, was finding it difficult to sort of push the very tough changes through. Tufan came into the business at a point where the platform was burning. And therefore, if they didn't make the changes, the business wouldn't survive. So never waste a good crisis, in other words. So what he's been doing

is going through the cost structure line by line. And that's not just people, it's procurement and materials. It is locations and consolidating some of those. It's also

on the revenue side, having those tough negotiations with your customers to make sure that the insurance contracts are profitable, taking every opportunity to do that. If it's increasing the time on wing, so if you can increase the time that the engine is on the wing of the plane, then that's positive in two ways. Number one, it's great for your customers. The customers love that in the sense that they can fly more and you're getting more on the LTSAs because you're getting paid per flying hour.

And you're extending the time to your next overhaul, which are very, very costly things. You've got to take the engine off the plane, bring it in, do the overhaul. So if you can extend that time on wing and you do that through enhanced use of data and making sure that you're really tracking the performance of your engines in real time so you can pick up any problems early so they don't become a huge problem in the future.

My follow-up question was going to be that I assumed you could only make that engine tied to wing dynamic work by releasing or putting into production higher quality engines that are going to last longer. It does sound like there are things that you can do while an engine is actually in service to ensure that that's happening. Is that just a matter of it's easier to fix a problem when it's small versus when it ultimately craps out?

Yes. Now, if your engineering is poor to start with, there's not a lot you can do. It takes an awful lot because you have to do some fundamental redesigns within the engine while it's in use. And that's an absolute nightmare. And that's what happened with the Trent 1000. The story with the Trent 1000 is there was a bit of a change in spec for the engine and Rolls-Royce, again, wanting to design the best engine, being an engineering firm, wanting to keep the customer happy. They

They said, "Okay, we'll change the spec halfway through," and that led to all sorts of issues and overruns and eventually a suboptimal engine. So now they're much more strict with, "Look, this is the best engine we have. This is how we're going to build it, and you can't just go changing the spec halfway through." That causes problems through the whole life of the engine. These things can go for a very long time. But it is both. The XWB is performing very well, but they will have issues along the way with it.

There's some evidence that in more dusty, hotter climates, it doesn't perform quite as well as they thought. So that means they can make some tweaks to those engines to help them perform a little bit better in those environments, etc. So you're always monitoring, using the data and trying to pick things up early.

Does the industry view Rolls-Royce as having higher quality engines than GE? I think it depends on the program. I wouldn't say overall there's a view that one company is superior to the other, but they're always trying to push to have the next level of engine in terms of efficiency and quality. That's a bit of a double-edged sword.

You can use the example of the wind energy industry. Any industry that makes these big machines is subject to this type of dynamic. In the wind industry, they make these big turbines, similar idea, massive bits of kit, and there's only a few players because these things are so expensive and so big. If you think of a wind turbine, it's a massive blade that turns when the wind blows. The way the industry went was the company that could make the most efficient blade,

the most efficient turbine got all the orders and we're still on this treadmill. There's this race. Every time a new turbine comes out, your back orders of your older turbines disappear because everyone orders the new one because it's the most efficient.

And it's the same for your competitors. So then you get this treadmill of trying to make the most efficient turbine and you're constantly putting in R&D, you're constantly putting in capital to get to the front end of that race so that you can get orders and win share. And it's decimating your R&D you've put into previous models and it really hurts competition. So when you're on that treadmill, it's a very, very tough industry to be in. And we've been in phases of that in the aerospace business historically with engines.

I think today it's much more stable because everyone recognizes this dynamic. Everyone wants to get to that next level of efficiency, but they're not working on it constantly and just bringing out engines that are slightly better. They're waiting to the point where the technology is such they can bring out a meaningfully better engine. And then probably GE and Rolls-Royce will both work on something similar

in concert, and then those will come out on a similar timeframe. Then you can share that market, keep it competitive for customers and ultimately for consumers. But that's a much more healthy dynamic for the industry. What is that timeframe between new models being released? You mentioned it seems like it's gotten longer, but any context there? I'm hoping it's gotten longer. You never know when the competitive juices kick in and the engineering juices kick in. There hasn't really been a point in the last...

25, 30 years where they haven't been in development of a new engine, I would say this is the first period.

where they're not putting in a huge amount of R&D for the next generation. Some of the R&D went in five to six to seven years ago, pre the current management team, when they're a little bit more on that treadmill. So there is a bank of R&D that's sitting there for the next generation, which probably comes out in the early 2030s, or at least they start in that production cycle in the early 2030s. So I think we're going to get now a five or six year period with

a bit of a quiet time for R&D for the next program. Also, you have to line it up with the air framers because the work on new engines will often sync with a new plane. If you look at the wide body market now, you've got the 350 from Airbus and the 787 from Boeing. They're both very good planes and they've got very reliable engines. Customers love them. Airbus has no big desire to start working on the next generation. That will come.

towards the back end of this decade, maybe early next decade. And then I think that's when you'll get some engine CapEx kicking up as well. Makes sense to have some synchronization between customer and supplier there. The CapEx and R&D intensity, can you frame that in terms of numbers, whether it's run rate or what you see in periods of time where it is elevated? Any context to that and generally tying it back to any free cash flow of the business?

can generate through cycles. In the many, many billions. The other reason you haven't seen many new entrances, it costs many, many billion to develop a new engine. And if you want to do the whole R&D upfront to get to the point where you can actually build it, start the program up, then you're in the tens of billions plus. For a high single digit margin business or low teens. Exactly. And then you'd have to break the market share of

It's just pie in the sky for anyone who's thinking about getting into this industry. In terms of free cash flow, if you have a good engine program, the engineering is good, and you've priced your LTSAs in a way that's appropriate for the risks in any engine program going forward, and you've got your costs under control, then this can be quite a free cash flow generative business. Because of the way the LTSAs work,

You don't have to build lots of working capital as you grow because you're getting a lot of your revenue back up front. If you think about a single LTSA for a single engine, what happens is as soon as that engine starts flying, you start getting some revenue in the door. And so you can think of that as negative working capital because you're not going to spend on that engine until the overhaul comes in sort of four or five. And it's significantly, you're spending a little bit over time.

So you can grow without a build in working capital, which means your free cash flow conversion is quite good. And if you price your contracts well, it can be a very, very free cash flow generative business. But we haven't seen it. And I think there's still a lot of skepticism with Rolls-Royce, especially because the history doesn't tell you that it's a free cash flow generative business. The history tells you it's lumpy and things go wrong. And occasionally you have a crisis and they have to get bailed out. It is a bit of a game of trust with this business. On the top line side of the equation,

Sounds like it's fairly straightforward in terms of engine sales and then certain amount of miles flown, which I would imagine track to the industry fairly closely. But is there anything else you would add in there just in terms of top line growth and the cyclicality to it or any other major drivers?

Very, very steady. So outside of pandemics. Yes. Besides that one big sudden stop. Yes. That's right. The growth drivers are quite good. On the OE side, you could say, oh, it's quite lumpy. But I mean, they've got this big order books. So there's quite a predictable order book in terms of the original equipment sales. On the order book, you did mention with the wind turbines that backlog of orders can sometimes go away.

I always find the order books to be so interesting across industries. Some are much stronger in terms of the contractual nature than others, but how reliable is that? There has been some lumps historically. I would say going forward, I would expect them to be very robust. There's a few underlying secular dynamics behind that. One is the number of people that fly every year.

tends to go up at a rate that's faster than GDP growth. The reason for that, of course, is that most people in the world don't have passports. Less than 10% of people in China have a passport. In India, the same, two massive populous nations. More and more people are entering that flying market. So you're getting a GDP plus growth rate in the industry as a base. But the most interesting thing, I think, in terms of today,

is that if you go from 2019 to today, the number of people flying is up as you'd expect it to be up given population growth and wealth growth over that five-year period. So a lot of growth in the demand for flying. But what's happened in that COVID period is there was a massive undersupply because of all the supply chain disruptions and disruption in production.

There's a massive undersupply. There's a hole in the supply of metal or planes into the industry. What that leaves you with is a very skewed supply-demand environment today. There's a massive demand for new planes to come into because you've got older planes rolling off the back end, and you've got this hole in the period where they weren't produced. And what I think that leads to, if you think of that structural GDP+, you're going to get GDP++ because that undersupply can't come all at once.

You can't just fill that hole all at once. It's gradual. And so you have this nice gradual tailwind over the next sort of five, six, seven years on the original equipment side. So that backlog, I think, is very secure. And then on the long-term service agreement side, it's just flying hours. So if people are flying a bit more, they're flying a bit less. That doesn't really move up and down that much. If you have a big recession, it'll move down a little bit and then recovers. But that's that GDP plus trend. Does Boeing's

challenges have any impact on Rolls-Royce? Not really, because the challenges have been in the narrow body segment. The wide body segment, which is really critical for Rolls-Royce in terms of its backlog, effectively, Boeing have a pretty reliable plane that people like.

Even if it had happened, though, to Boeing today in the widebody segment, it might have an impact on Rolls-Royce going forward, way into the future in terms of winning more business today. But the bulk of their free cash flow today is on those existing stock of engines flying around the world.

You've touched on it a few times, but this nuclear reactor business, which is this potential opportunity for them, is there any way to frame that actual size in terms of relative to the business or how big you think it could be? Just the timeframe for that playing out? It's not something that Rolls really talk about in any kind of promotional way.

because they don't make any money today from that segment. I mean, they have some business in existing traditional nuclear facilities, but in terms of the small modular reactors, they don't really discuss it. I think personally, it could be absolutely enormous in terms of the size of the market. If you just look at the UK, for example,

The UK currently delivers roughly six gigawatts of nuclear power to the UK market today, six gigawatts. The UK government and many governments around the world are increasingly recognizing that their grids are strained. This is becoming a very meaningful investment trend and political trend.

Grids are strained, and the more you put renewables into the system, the more they creak because of the intermittency of renewables. So you need good, solid baseload. What is that? It's coal, it's gas, it's nuclear. Coal is being phased out, so that leaves you with gas and nuclear, and obviously nuclear is the one without the carbon footprint. That's becoming an ever-increasing issue for everybody. So the UK government have a target by 2050 to get to 24 gigawatts of

of nuclear capacity versus six today. So a very meaningful step up. The most efficient way to get there is via small modular reactors. The difference between a small modular reactor and these big reactors that you see all around the world is the way that they're built. With a small modular reactor, you can build everything in a factory, in modules, literally think about

crate-sized modules that are very transportable. You build each piece in the factory, then you transport it to site, then you put it together like a big jigsaw.

That, if it's proven out on paper at the moment, is a much, much cheaper way to go and much more scalable. If you can get that to work on one or two, you can easily scale that up and it could become very, very efficient in terms of building nuclear capacity. If you need 18 gigawatt of energy just for the UK, that's 50 plus SMRs. That's just in the UK and they cost

one half, two billion each versus 10 billion for the last runaway horrific cost project in the UK in terms of their last nuclear bill. So it could easily be a hundred billion market and that's just in the UK and then scale that globally and you're into the trillions.

So a huge, huge market. So the only question is what margin can you make on it? What market share can you get there? Obviously, massive questions. But Rolls-Royce are a leader in this. They've got a lot of the regulatory approval already in the UK. I think they should win a mandate in the UK to push this forward. Then they become very much a poster child of the business. And then hopefully it goes from there.

Are there many competitors in that space today? Yes. People see the opportunity. Anyone with any capacity to do this, Westinghouse, et cetera, all of the ones you might think about are in the running.

Even if you can snatch 10% market share of a trillion dollar or a $10 trillion market, it becomes absolutely enormous in terms of the revenue potential versus the current size of the business today. And it's just that nice gradual tailwind. When you look at management's ability to allocate capital, we touched on some of the challenges that they've had in terms of getting the operational efficiency. But capital allocation, maybe there's not a significant opportunity to...

allocate free cash flow into various things. But how would you grade or assess the capital allocation of the business? Yet to be seen. The core of the business is engineering excellence, and that is still the core. What's happened recently is new management has come in and started to improve the business operationally.

I think the results so far are tangible, but the jury's still out in terms of the degree to which you can squeeze out operation improvements and make this a resilient and enduring business for the long term for society and for shareholders. Capital allocation, because you've not been in a position to...

assess what they do with free cash flow because there's been no free cash flow. That's an open question. But if you listen to what management is saying, they want to achieve investment grade status. They think they'll get that this year. That requires certain leverage levels, which they should easily hit given their current free cash flow level soon. It requires EBITDA margins above certain levels, which

They should easily hit as well, given where they are today. Once they get that investment grade status, then I think they'll continue to bring down debt, but their free cash flow should be meaningful at that point. I suspect in the kind of three to four billion pound range per year over the next four to five years. So very substantial, eight, 9% free cash flow yield on what hopefully is at its core, a very, very good business and one that is on an improving path.

In terms of assessing management's success with the operational improvement, are there certain milestones that you are looking for? Is there a certain time period where you think it will result in a fair measurement of whether it's a full year, a certain amount of quarters where you're seeing a shift in the trend line that you think is something concrete happening? Anything that you are...

using as a measuring stick to evaluate that particular thing. One of the things we like about new management is that they have put out very clear targets themselves. There's still a lot of skepticism from investors, and I think the market isn't reflecting fully the possibility that the management hit those targets. But what we like about the current setup is that they have set out their own KPIs

right down to explaining what they're doing in each division on the cost side, on the revenue side to drive value and to drive efficiency through the business. We're monitoring every quarter the results of the different divisions. But I think management are their own harshest critic in this regard. You think there's any risks that we haven't discussed? I think it's been a fairly balanced conversation, to be honest. But is there anything that we didn't touch upon that stands out as a risk to you?

The big risk, of course, is some fault in one of their key products. I wouldn't have put pandemic on the list of risks five, six years ago, but that was obviously a big hit as well.

The tail events, you never see them coming. And that one might be number one on the list. We wrap these conversations up talking about the lessons that you can potentially pull out from a particular company and apply elsewhere. Do you think there's lessons that stand out about Rolls-Royce from your investment process? So the one thing I would say is that we already knew, but it really does reiterate

the life of this investment. We originally invested in 2015 on a turnaround thesis. You live through turnarounds and you realize just how hard they are. And they're especially hard in normal times. So when we invested 2015, we were tracking the progress of all of the things they were trying to do to improve efficiency then. And it was going much more slowly than we'd hoped. And as I mentioned, paradoxically, it's the crisis that looked awful for the company.

And from the lens of most investors at the time that provided that burning platform, as the CEO described it at the time, from which to make the tough but necessary decisions to turn the business around.

That was, in hindsight, a great opportunity to own this business at the point when the market was absolutely terrified and it was only seeing the downside. So a key lesson might be that sometimes it's good to look at crises through a different lens, I would say, one that focuses on whether it can trigger structural changes that can drive significant value-add over time for the business.

This has been a joy to learn about. And I think we cover many companies that are several years past that turnaround or even decades past that turnaround. And we're mostly analyzing a success story. There's survivorship bias involved here, very much in the midst of something that's trying to go through that change. So I appreciate the perspective and appreciate all the knowledge around the business and the industry. Thanks, Matt. That's a lot of fun. Thank you.

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