Accounting and reporting to shareholders is a soft science at best. That annual report you’re reading isn’t the absolute truth. It’s an interpretation, a tainted one. The best you can hope for is it’s not too tainted.
It is the sort of thing analysts are reminded of every day. But few examples are as stark as UK giant Rolls Royce. The company makes power systems, most importantly engines for wide-body jet aircraft. We own Rolls Royce in the Forager International Shares Fund. We like the opportunity. We suspect the investment will do well and went in with eyes wide open to the issues about to be discussed..
But, as you’ll see, the accounts are tainted. Here are just a few of the instances where Rolls Royce’s reporting diverges markedly from how a rational shareholder might want things reported to them.
Mythical order book
The first digression occurs before the company even makes a sale. Rolls recently reported an order book of £76bn at 31 December 2015. That’s a book of future sales that stretches out for a decade. More than 85% of that order book relates to the civil aerospace business—engines for commercial aeroplanes—and includes both new engine sales and up to seven years’ worth of long term maintenance contracts.
Surely the company will make new additions to the order book in the coming years. And some of those maintenance contracts, which only include seven years of work in the order book, will run for decades. You might think it safe to assume, as a useful starting point though, that £76bn worth of contracted engines, parts and services in the order book will generate £76bn of sales over, say, the next decade.
The issue is that the order book is put together based on the ‘list price’ of the engines that have been ordered. The list price is a largely mythical construct. Well, it might apply if an airline ordered a single engine, for delivery next week, to the Gobi Desert. But otherwise, buyers always get a discount. You won’t find the scope of those discounts anywhere in the annual report. But they’re massive—quite a bit more than 50% on forward orders of whole engines, and perhaps 10-20% on aftermarket parts. Of that claimed £76bn order book, we’d guess at least £30bn will never flow through as revenue to the company. Thirty billion pounds!
Any analyst worth their salt can work this out and work around it. It gets more complex when we move on to the accounting for actual sales.
In the recent Forager Funds December 2015 quarterly letter, we describe Rolls’ engine business as being a version of the ‘Gillette model’. Gillette is happy to sell razor systems for no profit, because it makes so much profit on the blades it will subsequently sell you.
Somewhat similarly, Rolls Royce sells its aircraft engines at an underlying economic loss, typically in the vicinity of 10% of purchase price. But, over the life of that engine, the company makes 3-4 times as much revenue from parts and service, typically at underlying economic profit margins of 25% or more.
Note I said underlying economic profit/loss. Because what goes through the actual profit and loss account is very different indeed.
Imagine an illustrative but realistic sale of engines that generate £100m of revenue on delivery of the engines, with a 10-year parts and service contract signed to maintain those engines that generates £15m of aftermarket revenues annually. So the company can expect to generate £250m in total sales from the contract, £100m in original equipment sales and £150m in aftermarket parts and service revenues over the subsequent decade.
Chart 1 below highlights the earnings before interest and tax (EBIT) on that mythical contract based on various accounting standards.
The blue line, titled ‘Underlying’, highlights how the company would report this deal if I owned Rolls Royce outright, and fairly closely matches the company’s real cash flow position. The company loses about £10m on the original sale (a 10% loss), but makes 25% profit margins in the subsequent aftermarket revenues to follow.
In stark contrast, the orange line describes how Rolls Royce actually accounts for profit when the engine and aftermarket contract are signed at the same time, called ‘linked’ accounting. Instead of ‘losing’ 10% on the sale price and gaining 25% on aftermarket revenues, they work out a blended margin (11% in this case, it turns out) and apply it to all revenues as they are received.
Thus, a loss of £10m on the original sale becomes a profit of £11m. Not bad huh. Except that profit won’t represent real cash coming in the door, and they’ll need to fund the difference. Note the profit over the whole life of contract is the same, at £27.5m, But they’ve completely ‘front ended’ the profit of the contract, over-reporting on the initial sale and under-reporting an offsetting amount of profit on service revenues over the rest of the decade. It’s a neat accounting trick.
It’s important to point out that this example is not perfectly accurate, the accounts actually shift a little revenue around too. But the point is simplified and roughly right.
The grey example highlights how the company records profit when the original sale and aftermarket contracts are signed separately and independently, and thus cannot be linked because accounting standards won’t allow (usually separate contracts with the airframe manufacturer, Airbus or Boeing, and a separate maintenance contract with the ultimate aircraft owner, usually an airline or lessor). These are called unlinked sales. In this case, they don’t report a profit on original sale but they do ‘capitalise’ the loss, and amortise it (feed it through the profit and loss statement as an expense) over the subsequent life of the maintenance contract. The accounting treatment isn’t as aggressive as linked sales, but it’s still head in the sand stuff.
Not only do we currently have the company aggressively bringing forward profits but, because of changes to the nature of the industry, the business is shifting from predominately linked sales to predominately unlinked sales. Whereas the business was 80% linked a few short years ago, it will be 80% unlinked a few more years from today.
This shifting mix is creating massive complexity. While the above example of one contract is easy enough to understand, piecing it together on a whole-company basis is torture. Rolls is now reporting new sales with less aggressive accounting treatment, some older (linked) sales that massively over-report genuine economic profit, older (linked) maintenance contracts that underreport economic profit and cash flow, and newer (unlinked) maintenance contracts that are somewhat closer to economic reality but still skewed.
As Charlie Munger is fond of saying, when you mix raisins and turds, you get turds.
And so analysts look into their bag of tricks for workarounds. Here’s one of the simpler ones. You focus purely on the Aftermarket business—parts and service—that is the real goldmine of this operation. If we can understand that profitability well, and make some deductions for expected losses on original equipment sales, we’ll be 90% there.
The chart below, which is published in every Rolls Royce result, thus becomes a useful analytical tool. It highlights how many million pounds of thrust there are in the installed base of engines on service contracts with Rolls Royce. The installed base is a very good guide to future maintenance revenue growth. And as you can see, a chief part of the bull case for the stock, it’s destined to grow very rapidly over the next decade. That’s great. Work out what is the fair underlying economic profit on today’s installed base, amplify it for the coming growth, make some necessary deductions. Margarita time.
Oh come on, surely you know by now that it’s never that easy.
While Rolls Royce tends to legally own 100% of each engine program, the economic reality is, once again, a bit different.
A significant proportion of the materials and labour that goes into each engine and each spare part comes from outsourced partners—typically more than 75%. And, while some of those suppliers do it for standard pay as you go rewards, more crucial partners often have a financial stake in the engine program via a so-called risk and revenue sharing model. So if a new engine model goes well, some partners share the spoils. If it flops, they share the pain. It’s good risk management on Rolls Royce’s part.
And the percentage of ownership that effectively belongs to partners on the new model engines, at around 35-40%, is much higher than on the older models. Again, you won’t find those numbers handily in print in the annual report. But they’re crucial to understand.
They’re important because chart 2 above, and the numbers that underlie it, are based on gross thrust, not Roll Royce’s net share. And so that chart overstates the coming growth from Rolls’ shareholders’ perspective. Don’t adjust for it and our simple workaround, designed to cut through the complex accounting, falls flat.
I’ve talked with several very numerate Rolls Royce shareholders that had missed that point.
So there you have it – a company with a wide and deep moat and, finally, decent management. Its accounting is, like its engines, firmly in the clouds. The bears are underestimating it and some bulls are surely overestimating it. We own the stock, but will do so with a healthy level of scepticism in any business where the accounting is this opaque.
Ready to invest?
Visit this page for more information on how to invest with Forager.
Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.