Rolls-Royce Holdings (LSE:RR., Financial), based in the U.K. and a leading producer of engines for the aerospace sector, was the largest detractor for this quarter, returning -16% and down approximately 60% year to date. As we discussed during our last quarterly write-up, we believe that the coronavirus has only modestly affected the intrinsic value of most of our holdings. Unfortunately, this is not the case with Rolls-Royce. We think that the coronavirus will cause a material and long-lasting disruption to the company’s civil business. This segment accounted for approximately 55% of the company’s 2019 revenue and generated most of its cash flow primarily due to its dominance in the wide-body jet engine market. However, the vast majority of wide-body aircraft are flown on international routes, and with nearly all international traffic grounded, wide-body flight hours decreased 90% year-over-year during the second quarter. Although we expect international air travel to recover in the coming months, we believe it will not return to 2019 levels for many years. As a result, we’ve significantly decreased our earnings forecasts for the company’s civil business, which is now likely to be a smaller and less profitable part of the business than we had assumed at time of initial investment. Fortunately, Rolls-Royce has other businesses, namely power systems and defense, which combined are nearly the same size as the civil business and have been much less disrupted by the coronavirus. The recent share price correction, though, implies that all of the company’s businesses have declined as much in value as the civil business has, which we believe is not the case. We estimate that the value of the power systems and defense business exceeds the current quote, implying the market believes the civil business has negative value. Although the civil business could report a couple years of losses and negative cash flow, we believe the business still has positive long-term value. Rolls-Royce has been a poor investment to date, but we think its current risk-return profile is favorable. Thus, we remain shareholders, despite a significant reduction in our estimate of the company’s intrinsic value.
From David Herro (Trades, Portfolio)'s Oakmark International Fund's second-quarter 2020 shareholder commentary.
