Rolls-Royce (LSE:RR., Financial) was the one new purchase in the period. The company is a leading producer of engines for the aerospace sector, and it is particularly exposed to wide-body aircraft, where it operates in a duopoly with General Electric (GE). The wide-body market is coming up on a strong replacement cycle. In fact, we estimate that 50% of Rolls’ incremental wide-body engine deliveries will come from replacement demand. In civil aviation, the net present value of a new aircraft engine platform involves years of accumulating losses during the development and early production phases, which is followed by a lucrative aftermarket stream (what is referred to as the “razor and razorblade model”). Rolls’ current levels of profitability and cash flow are depressed because it is participating in two simultaneous, major development/ramp-up projects while it also addresses its internal inefficiencies. We expect the company’s profitability and free-cash-flow generation to improve over the next three years as development costs normalize and the lucrative aftermarket stream begins to contribute. Moreover, we believe there is significant scope for self-help initiatives as CEO Warren East overhauls a weak management team, improves accountability and modifies incentives to emphasize cash-flow generation. We believe the market is overly concerned with short-term profitability and cash flow, particularly given the numerous opportunities to improve both metrics over the medium term. We see a very favorable risk/reward profile, so we established a position during the quarter.
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