CEO Steers New Course for Rolls-Royce

04/12/2016 10:00 am EST

Focus: STOCKS

George Putnam

Editor, The Turnaround Letter

This turnaround idea is based in the United Kingdom and is one of the largest producers of high performance aircraft engines in the world, notes George Putnam, editor of The Turnaround Letter

With roots in the earliest days of aviation, Rolls-Royce Holdings (RR) makes engines that power the new Boeing 787 and Airbus 380.

It’s engines are used in military aircraft, marine vessels, nuclear submarines and power generation systems. Its customers include over 380 airlines, 160 armed forces, 70 navies and more than 5,000 power companies. 

We note that the legendary Rolls-Royce Motor Car business was separated in 1973, and is now part of BMW (BMW).

In recent years Rolls-Royce Holdings has stumbled. Plagued by strategic problems and investors’ sense that management was not on top of the situation, its shares have fallen by over 50% since early 2014.

We think Rolls-Royce’s future is much brighter than its past troubles imply. First, it has many valuable assets, including an oligopoly position in a critical industry with high barriers to entry. 

Moreover, its solid balance sheet, with $3.2 billion in cash nearly offsetting its debt, provides financial flexibility.

The catalyst to unlocking the value in these assets is new CEO Warren East, who joined last July and is bringing a renewed sense of urgency and focus to the company. 

East previously led technology company ARM Holdings (ARMH) for 13 years, growing sales from $145 million to over $900 million.

East’s top priorities include focusing new investment on the higher-value businesses and streamlining unwieldy manufacturing costs. 

We also like the presence of respected activist investor ValueAct who has recently become a 10% shareholder and is pressing for a board seat. 

I addition, valuation is attractive. Based on the depressed near-term outlook for 2016, the shares trade at 19.9x earnings and only 7.7x cash flow. 

As new management gets the business back on track, earnings, cash flow and the multiples should all improve, pushing the stock price up substantially.  We recommend buying Rolls-Royce ADRs up to $14.

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By George Putnam, editor of The Turnaround Letter 

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