If there’s one quality Warren Buffett and many other big-time investors look for in a potential investment it’s a “wide moat to entry” — a sustainable competitive advantage that deters newcomers and protects the company’s market share over the long term.
Moats don’t come much wider than designing and manufacturing engines for airplanes, a somewhat critical part in the process if you don’t want your plane to crash. That’s where Rolls Royce (LSE: RR) comes into the picture thanks to its duopoly with GE in the global market for engines on wide-body aircraft.
Despite roughly splitting market share with GE, the past few years have been rough on Rolls0Royce, as a series of profit warnings sent share prices tumbling just as a new CEO was brought on board to right the ship. The big problem for Rolls has been a rather bloated organisational structure and relative lack of investment in new methods of manufacturing that led to low margins in the civil aerospace division, where the majority of its revenue is booked.
In 2015 underlying operating margins for Rolls’ civil aerospace division fell to 11.7% from 13.8% year-on-year, a far cry from the 22.4% posted by GE’s aircraft engine operations in 2015. However, if you’re a glass half full type of person, this provides a massive opportunity for margin improvement if the new management team can learn from GE’s recent performance.
In the short term, the problems facing this critical division along with struggles in the market for maritime engines, which has been hit by falling demand for offshore oil rig engines, means Rolls has several years of a painful turnaround process ahead of it. But, if for no other reason than its enviable position in the growing market for wide body aircraft engines and potential upside from cost-cuts and operational improvements, I’ll be following Rolls’ progress closely in the coming quarters.
Rising demand
One company that hasn’t let its wide moat go to waste is global cigarette giant British American Tobacco (LSE: BATS). Smokers are notoriously loyal to their chosen brand and BATS has taken advantage of its bevy of household names to up prices enough that operating margins over the past six months were an astounding 33%.
And, contrary to what public health officials and insurers would want, global demand for cigarettes is still increasing at a healthy clip. In the first half of this year, organic revenue growth was a solid 6% as the company shipped 2.1% more cigarettes year-on-year.
Growing revenue and high margins leave significant cash on the income statement that BATS has no problem returning to shareholders. Dividends have been steadily increasing and analysts are expecting them to yield 3.5% this year.
Add in relatively reliable revenue, after all smokers don’t quit simply because of a recession, and it’s no secret why investors have flocked to BATS for a long time. The downside to all this good news is that high demand means the shares are looking pricey at 20 times forward earnings. But at the end of the day, you pay for quality and thanks to its wide moat, high margins and steady dividend, BATS earns its place at the top of my watchlist.
