Power systems company Rolls Royce (LSE: RR) had delivered a fantastic five-year total return of over 330% before the shares hit a sudden slump in February. Cutbacks in defence spending have forced the company to lower revenue and profit guidance twice this year and it is now predicting either flat or falling profits for 2015. The shares now trade at a 28% discount to their February high, but is this an opportunity to buy into one of the FTSE’s greatest success stories, or is Rolls Royce a business in decline?
Two lost years of growth
The company looks unlikely to grow at all in financial years 2014 or 2015, but management have been keen to point out this is only a short-term issue. John Rishton, CEO, said:
“While the short term is clearly challenging, reflecting the economic environment, the prospects for the Group remain strong, driven by the growing global requirement for cleaner, better power.”
As investors it would be imprudent to blindly accept management’s word as fact, but in this case I believe Mr Rishton to be correct. I look to buy businesses for the long term, so even a two-year stall in earnings doesn’t bother me much as long as the long-term hypothesis for investing is sound.
Here is why I believe Rolls Royce could be set to prosper in the coming years, and why this price weakness could be the best chance we get to invest in a company with a compelling growth story.
Innovation to dominate growing markets
Research and development is at the heart of Rolls Royce, their mission statement being to provide “better power for a changing world”. They acknowledge that providing more efficient machines will drive custom their way and are determined to improve their offerings. Their network of R&D facilities and financial dedication to building better machines has led them to the top of their market, and it will keep them there as long as they can continue to advance their products.
While the economic outlook for the next few years is poor, if Rolls Royce can maintain their market share through innovation there is some incredible opportunities for them in the future. Rolls Royce predicts a requirement for 27,000 new aircraft to be delivered before 2023. This represents a 55,000 engine opportunity for the sector, and the global civil engine market as a whole will be worth $1,750bn over the period. Over half of this figure is allocated to twin aisle airliners and large business jets, where Rolls Royce has the dominant market share. If Rolls Royce continues to lead this sector, it should experience a massive uptick in demand for its engines beyond 2015.
While it may not be their largest business, Rolls Royce also researches and builds nuclear technologies, such as submarine engines and power plant technology. Originally, the energy department focused on oil and gas, but the diversification into nuclear energy once more proves the company’s ability to adapt to an ever-changing world. Clean energy was back in the spotlight recently, as a UN commissioned report warned we must respond quickly to hold global warming to a manageable 2 degrees Celsius increase. It is likely we will eventually move away from fossil fuels, and while no one can be sure what our next major energy source will be, it is good to see Rolls Royce diversifying and researching possibilities to chase a first mover advantage, instead of waiting until their products are obsolete.
True Quality Going Cheap
Trading on a PE of 12, yielding 2.5% and with zero growth forecast, Rolls Royce is certainly not dirt cheap. However, truly quality companies never are. I’m willing to stock up on the shares while it trades at these levels as long as it can demonstrate continuing innovation.
Zach Coffell has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.