Business Breakdowns: Rolls-Royce – Turbines and Tribulations

Episode Overview

Main theme:
This episode of Business Breakdowns, hosted by Matt Reustle and featuring guest Graham Forster (Orbis Investments), takes an in-depth look at Rolls-Royce Holdings plc—the iconic British engineering company best known today for its aerospace and power systems businesses. The discussion moves from the company's rich history through to its unique business model, value drivers, competitive dynamics in the aircraft engine duopoly, operational challenges, turnaround efforts, and future opportunities (notably, small modular reactors in nuclear energy). The conversation is candid, punctuated by historical context, industry insights, and an honest assessment of the turnaround journey.

Company Overview and Historical Context

Rolls-Royce Today ([04:29])

• Core business:
  “The company at its core, the way I think about it, is as a power business. So mainly converting stored energy into kinetic energy.” — Graham Forster [04:29]
• Segments:
  • Civil aerospace (large engines for commercial aircraft & business jets)
  • Power systems (marine, industrial, backup generators)
  • Defense (notably nuclear submarine propulsion)
  • Energy generation & storage, including nuclear and electrification initiatives

Historical Roots and Brand Evolution ([06:44])

• Origins:
  Founded in 1906 by Charles Rolls & Henry Royce—one entrepreneurial, one a perfectionist engineer.
• Auto to Aerospace:
  Started in automobiles, then pivoted to aircraft engines (WWI), pioneering jet engines in WWII.
• Separation of Businesses:
  “As part of that nationalization, the car business, the original piece of that business was spun out and that was sold off as Rolls-Royce Motors... And then Rolls Royce plc, the large engine business that we're here to talk about today.” — Graham Forster [09:54]

Culture & DNA

• Obsession with perfection and engineering excellence—dating back to Henry Royce:
  • “Whatever is rightly done, however humble, is noble.” — Henry Royce (quoted by Forster) [05:00]
• The culture of relentless quality persists across both the automotive (now BMW-owned) and industrial arms, even though the businesses have diverged.

Business Model and Value Drivers

Revenue Breakdown ([12:48])

• Civil Aerospace (~50%):
  Large engines for widebody aircraft, business jet engines.
• Power Systems (~25%):
  Off-highway engines, marine, industrial, energy production, data center backup.
• Defense:
  Engines for naval ships, nuclear submarine reactors.
• Emerging/New Markets:
  Especially Small Modular Reactors (SMRs) for nuclear energy.

The Engine Duopoly ([15:57])

• “They tend to have very strong market positions, especially in the bigger engines... after many, many decades. So it's a super stable industry.” — Graham Forster [15:57]

• Market share:

  • ~50% share in new widebody engine orders, ~30-40% of installed base (and growing)
  • Duopoly with GE in widebody jet engines

Go-to-Market & Revenue Recognition ([17:44])

• Engines generally co-developed with Boeing/Airbus, sold at low margin to airframers.
• Real profit comes from aftermarket service agreements with airlines:
  • Long-Term Service Agreements (LTSAs, 10-13 years), “sticky” due to complexity and proprietary data
  • “That's where the majority of the margin is made for Rolls Royce.” — Graham Forster [18:12]
  • Services priced based on hours flown; akin to writing insurance policies ([23:12])

The Insurance Analogy ([21:42])

• Operators pay Rolls-Royce per flying hour; Rolls covers all scheduled and unexpected maintenance, taking on significant risk (akin to insurance underwriting).

• “These long term service agreements, they should be really very good business through the cycle. And I think historically they haven't been for Rolls and that's an interesting dynamic, but they're doing a lot today to make sure that that becomes how it should be.” — Graham Forster [22:28]

Financials, Profitability & Operational Dynamics

Margin & Profitability ([31:02])

• Margins are currently lower than competitors (GE in the 20%+ range, Rolls-Royce in low teens).

• Goal: raise civil aerospace operating margins from low teens to high teens (%), improving cost discipline and pricing structure further.

• “The efficiency of the whole of Rolls Royce is below where it should be... So in the civil aerospace, which is probably the most important in terms of profit going forward... it's sitting low teen operating margins. And they think, and we think they can get to high teen over the next five or six years.” — Graham Forster [31:16]

Why Historically Underperformed? ([25:17])

• Engineering-first culture: focus on product excellence rather than commercial discipline has historically led to underpricing and insufficient margin capture.
• GE seen as commercially savvier.
• New management (from 2022): sharper focus on profit, cost controls, procurement, and pricing. Crisis (Covid) provided the burning platform for change: “Never waste a good crisis.” ([33:04])

Industry Dynamics—R&D and Capex ([41:46])

• Huge upfront capital required for engine development (tens of billions per new model).
• Limited new entrants due to scale, complexity, up-front investment.
• Free cash flow conversion potential is strong with well-priced contracts and well-run programs, but track record is lumpy and crisis-prone ([42:08], [43:54]).

Competitive Position and Industry Structure

Barriers to Entry

• Immense scale necessary; only a handful have survived for decades.
• “It costs many, many billion to develop a new engine ... and then you'd have to break the market share. It's just pie in the sky for anyone who's thinking about getting into this industry.” — Graham Forster [42:03]

Engine Replacement and Cycle ([19:10], [20:58])

• Engines last decades (30-40 years), regularly overhauled—engines effectively get “rebuilt” every 4-5 years.
• Rolls-Royce’s data, servicing and infrastructure make customer relationships very sticky.

Market Share and Duopoly ([28:35])

• The wide-body aircraft market wants at least two healthy competitors, so Rolls and GE optimize for margin, not just share.

OEM & Airframe Relationships ([30:01])

• Trend towards exclusive engine contracts (e.g., Airbus A350 only uses Rolls-Royce XWB).
• Pros: scale, tighter airframe-engine integration, performance optimization.

Risks, Turnarounds, and Opportunities

Risks ([53:31])

• Major product failures or quality issues (e.g., the Trent 1000 engine problem).
• Unpredictable “tail events” (Covid, major accidents).
• Historic volatility: frequent “lumpiness” and the company occasionally requiring bailouts.

Turnaround Lessons ([54:13])

• “Paradoxically, it's the crisis that looked awful for the company... that provided that burning platform... from which to make the tough but necessary decisions to turn the business around.” — Graham Forster [54:13]

Management, Capital Allocation & Future KPIs ([52:49])

• New management more target- and KPI-driven; admitting skepticism is warranted.
• Path to investment grade status (targeted for 2024/25); leverage and EBITDA targets laid out.
• “There’s still a lot of skepticism from investors, and I think the market isn’t reflecting fully the possibility that management hit those targets.” — Graham Forster [52:49]

Order Book, Top-Line Growth & Aviation Cyclicality ([44:28])

• Order book now robust—Covid created a backlog and supply-demand imbalance, setting up “GDP++,” multi-year tailwind as demand for new planes and engines recovers.
• “That backlog I think is very secure. And then on the long term service agreement side, it’s just flying hours… GDP plus trend.” — Graham Forster [46:00]

Future Opportunities: Small Modular Reactors ([47:05])

• Possibly enormous future market for SMRs as energy grids seek zero-carbon baseload power.
• “If you need 18 gigawatt of energy just for the UK, that’s 50 plus SMRs, that’s just in the UK... Could easily be a hundred billion market and that’s just in the UK and then scale that globally and you’re into the trillions.” — Graham Forster [49:34]
• Rolls-Royce well positioned, but revenue and margins still unproven.

Memorable Moments & Quotes

“At its core … converting stored energy into kinetic energy… Rolls Royce still has that consistent DNA ... an obsession around the quality and how everything comes together in this sort of perfect way.”
— Graham Forster [04:29-11:21]

“You can almost compare it to writing insurance … Rolls Royce gets paid a premium on these long term service agreements … It’s essentially direct insurance.”
— Graham Forster [21:44-23:20]

“Never waste a good crisis.”
— Graham Forster [33:04]

“Paradoxically, it’s the crisis … that provided that burning platform … from which to make the tough but necessary decisions to turn the business around.”
— Graham Forster [54:13]

“You live through turnarounds and you realize just how hard they are, and they’re especially hard in normal times.”
— Graham Forster [54:13]

Important Timestamps

• [04:16] – What is Rolls-Royce today?
• [06:44] – History & Auto/Aero split
• [12:48] – Business segments & value drivers
• [15:57] – Market share and duopoly structure
• [17:44] – How engines are developed, sold, and serviced
• [19:10]/[20:58] – Engine lifecycle, maintenance, and "insurance" model
• [23:20-25:17] – Why the model was less profitable historically
• [31:02]/[32:11] – Segment margins & comparison to GE
• [33:04-36:51] – Turnaround, cost cutting, management change
• [41:46] – R&D, capex, and barriers to entry
• [47:05] – Nuclear SMR opportunity
• [52:49] – Management targets, KPIs, and the turnaround measuring stick
• [54:13] – Investment lessons and turnaround challenges

Key Takeaways

• Rolls-Royce is a leader in a highly concentrated industry, with competitive advantages rooted in culture, engineering, and customer stickiness via long-term service agreements.
• Profitability lags peers due to historic underpricing and cost issues—under new management, a turnaround is well underway, aided by crisis-driven urgency.
• The company’s next era may include transformative gains if small modular nuclear reactors become a reality.
• Investing in turnaround stories requires patience, a contrarian mindset, and the ability to see opportunity in crisis.

For further insights or to explore more business breakdowns, visit joincolossus.com.