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One way to capture the civilian aerospace boom is to sit in the cockpit with Airbus and Boeing. Another is to book a window seat overlooking the engines, alongside Rolls-Royce. There is a difference. The former earn their profits by making and selling airplanes. But manufacturing is only half the story in the engine business. Some 50 per cent of Rolls-Royce's £12-billion ($18.6-billion) revenue for 2012 comes from maintenance, repair and overhaul (MRO). The company can monitor its newest engines in the air and alert airlines if action is required. One day, all manufacturing might look like this.
Rolls-Royce does not reveal how much profit it generates from after-market services, though RBC Dominion Securities estimates that it could be 60 to 70 per cent of group operating profit (£1.4-billion last year). The share is likely to grow as the company ramps up production of wide-body engines for the Boeing 787, Airbus A380, and other new large aircraft. Rolls-Royce turned out 275 wide-body engines in 2012, compared with 224 in 2011, and is aiming for about 500 a year by the middle of the decade when a new plant in Singapore is fully operational.
That should enable the group to address a key weakness – cash generation. Rolls-Royce spends a lot on infrastructure and research and development, and is not yet at the peak of its investment phase (when it is, start worrying). Free cash flow in 2012 was just about break-even. It had net cash of £1.3-billion, so its balance sheet is robust. If investment begins to flatten out and production picks up, the group's cash position will be strengthened.
The question is whether that will result in a rerating. Rolls-Royce's shares are near their all-time high and trade on a multiple of 14 times forward earnings, on a par with the sector. If it can generate more cash, given the visibility of its earnings, it surely deserves a premium.