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Rolls-Royce Holdings PLC: Buy, Sell Or Hold?

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I hope to pinpoint the very best buying opportunities in today’s uncertain market, as well as highlight those shares I feel you should hold… and those I feel you should sell!

I’m assessing every share on five different measures. Here’s what I’m looking for in each company:

1. Financial strength: low levels of debt and other liabilities;

2. Profitability: consistent earnings and high profit margins; 

3. Management: competent executives creating shareholder value;

4. Long-term prospects: a solid competitive position and respectable growth prospects, and;

5. Valuation: an under-rated share price.

A look at Rolls-Royce Holdings

Today I’m evaluating Rolls-Royce Holdings (LSE: RR)(NASDAQOTH: RYCEY.US)], a British multinational company that provides integrated power solutions such as gas turbine engines, fuel cells and gas compression, which currently trades at 1,197p. Here are my thoughts:

1. Financial strength: The company is in solid financial health with net cash of £1.3bn, interest cover of 40 times, and robust free cash flow averaging around £500m over the past 5 years.

2. Profitability: During the past ten years, the company has doubled its revenue, tripled its order book and increased adjusted earnings per share more than fivefold; operating margin has consistently been around the high-single digit to low double-digits; and return on capital employed has been very good, averaging 16% per year.

Also, recently, the company released solid half-year results:

  • order book increased to £69bn from £60bn at the end of 2012;
  • underlying revenue was up 27% from the previous year to £7.3bn;
  • and pre-tax profit increased by 34% from the previous year to £840m.

3. Management: John Rishton, the company’s current chief executive, has a tough act to follow. He replaced one of the most highly regarded chief executives in Sir John Rose, who retired on March 2011 and was Rolls-Royce’s CEO since 1996. During his tenure, the company’s order book grew from 7.6bn in 1995 to around £60bn in 2010; revenue from £3.6bn in 1995 to £11bn in 2010; and profit from £175m in 1995 to £540m in 2010.

4. Long-term prospects: Rolls-Royce Holdings operates in four major business segments: civil aerospace, defense aerospace, marine and energy. The company makes money not only from selling its engines but also a huge part of revenue — 52% in 2012 — is generated from repair, upgrade and maintenance services, which the company packages with its products. Thus, as the company’s installed base of products grows so does its service network.   

The company is a major manufacturer of aero engines for commercial aircrafts, powering more than 30 types of commercial aircraft and 12,500 engines in service with customers around the world. It is the market leader in the modern, wide body and the corporate market segments. Also, the company is the second largest provider of defence aero-engine products with 18,000 engines in the service of 160 customers in 103 countries and is the market leader in military transport/patrol market with over 8,000 engines in service.

However, the company also faces a number of headwinds: defence spending in developed markets have remained flat for the past few years; while European economies remain weak and the US recovery still looks shaky; and also, growth in emerging economies Asia and Latin America have been subdued.

Nonetheless, Rolls-Royce’s future looks very promising, according to the company — global market demand for its products is set to grow to around US$3 trillion over the next 20 years.

5. Valuation: Rolls-Royce shares are currently trading at a premium to its 10-year price-to-earnings (P/E) ratio average of 14.5 with a forward P/E of 19. It also returns a prospective dividend yield of 1.85%, three times covered.

My verdict on Rolls-Royce Holdings

Rolls-Royce is a good company. It is the market leader in several of its end markets; it has a healthy balance sheet; a good track record of growing revenue, earnings and dividends; and earns very good returns on capital. Also, the long-term outlook for the industry looks very rosy. However, Rolls-Royce shares are already trading at a forward P/E of 19, and look fully priced at best. Unless the company has a really strong competitive advantage, I remain sceptical about future growth and would only buy at a discount, especially considering that defence spending and global growth remains subdued. Therefore, I am only prepared to buy Rolls-Royce shares at a lower price; I can find better value elsewhere.       

So overall, I believe Rolls-Royce at 1197p looks like a hold.

More FTSE opportunities

Although I feel Rolls-Royce is a hold right now, I am more positive on the FTSE shares highlighted in “8 Dividend Plays Held By Britain’s Super Investor“. This exclusive report reveals the favourite income stocks owned by Neil Woodford — the City legend whose High Income fund turned £10,000 into £193,000 during the 25 years to 2012.

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In the meantime, please stay tuned for my next verdict on a FTSE 100 share.

> Zarr does not own any share mentioned in this article.

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