Monday, November 25, 2013

A British Blue Chip Ups the Ante

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A British Blue Chip Ups the Ante

John Persinos Investors who doubt that aviation is in full-throttle recovery should look to the Middle East—specifically, Dubai.

The largest city in the United Arab Emirates, Dubai is home to a biennial gathering of the biggest players in commercial and military aviation. Held this year from November 17-21, the Dubai Airshow reported a cumulative order book in excess of $200 billion, the highest value of aviation deals ever signed at a single event anywhere in the world. By way of contrast, Dubai 2011 generated an order book of $63.3 billion, which at the time was considered a healthy number.

One of the biggest winners at last week's show: Rolls-Royce Holdings PLC (OTC: RYCEY).

If you had heeded my recommendation to buy Rolls-Royce when I first recommended the stock in an Investing Daily article on August 30, 2012, you'd now be sitting on a total return (capital gain plus dividends reinvested) of about 60 percent, more than double the 28.3 percent return of the S&P 500 during the same period.

And if the recently concluded Dubai Airshow is any guide, this storied company still faces room for growth that's as wide as the desert.

London-based Rolls-Royce is the world's second-largest maker of aircraft engines, behind General Electric (NYSE: GE). A famous brand name associated with premium products, Rolls-Royce split from the eponymous luxury car maker in 1973. With 55,600 employees worldwide, the company makes engines for military and civilian aircraft, as well as power plants for other industries.

And Rolls-Royce was on a roll in Dubai. The company announced last week at the show that it had won a $5 billion order from Abu Dhabi's Etihad Airways for Trent XWB engines to power 50 Airbus A350 aircraft. The order includes long-term maintenance of the engines.

Aircraft maker Airbus, the main rival to Boeing (NYSE: BA), is a subsidiary of the European Aeronautic Defence and Space Company, or EADS (OTC: EADSY).

Rolls-Royce also announced at the show a $300 million order from Qatar Airways for Trent 700 engines, also with maintenance support, to power five Airbus A330 freighter aircraft, with options for eight more.

The Trent 700 is the most popular Rolls-Royce engine type, currently powering more than 530 A330 aircraft with 58 operators. More than 1,400 Trent 700 engines are either in service or on order.

Rolls-Royce had been racking up new orders this year, even before the Dubai show. Notably, on October 7, Japan Airlines ordered 31 Airbus 350 XWB aircraft that are powered by Trent XWB engines.

More and more air carriers are clamoring for advanced engines such as Rolls-Royce's Trent series. The International Air Transport Association (IATA) recently forecast that the civilian airline industry would generate revenue of $671 billion and earnings of $10.6 billion in 2013, driven by increases in passenger traffic. Last year, air carriers racked up revenue of $637 billion and earnings of $6.7 billion. The IATA also reported that global airlines would invest $3.5 trillion to buy 27,800 new airplanes over the next two decades.

As you can see from the chart below, air travel and cargo volumes are growing significantly, a trend that fuels demand for aircraft engines:

Climate Change Anxieties

The growing ferocity and frequency of severe weather events—such as this month's Super Typhoon Haiyan in the Philippines—is feeding public fears of climate change, prompting regulators in governments around the world to implement strict new rules to combat greenhouse gas emissions. Many of those rules are falling on aviation.

Meanwhile, global economic recovery is driving a huge increase in air travel, particularly in emerging markets where a rising middle class is embracing tourism. The growing volume of passenger traffic boosts jet fuel consumption, as well as pollution. Jet fuel accounts for roughly a third of airline operating costs and its price over the past several years has stayed at a sustained high level.

Consequently, air carriers with aging, fuel-hogging and pollution-intensive fleets are plowing greater capital expenditures into "green" aviation technology. These advancements in engine design not only help the planet, but they also enhance air carriers' fragile operating margins.

As the world's leading maker of low-emission, fuel-efficient aircraft engines, Rolls-Royce is the best play on the secular trend toward eco-friendly aviation.

More than half of Rolls-Royce's annual revenue stems from civil aerospace; the rest is divided among defense, marine, and energy.

Rolls-Royce also is leveraging the sustained boom in the energy sector. The company's energy segment manufactures and sells power systems for the offshore oil and gas industry, with a product portfolio that includes gas engines, gas turbine engines, gas compression equipment, diesel engines, fuel cells, and automation and control systems.

With a market cap of $22.9 billion and $5.53 billion in cash on its balance sheet, Rolls-Royce has the wherewithal to maintain strong research and development into new engine technologies for a variety of industries. Aviation engineers in North America and Europe are working hard in their workshops to devise new and cleaner aircraft engines, but Rolls-Royce is already the leader in next-generation designs.

The Rolls-Royce Trent 1000 turbofan engine, which powers Boeing's 787 Dreamliner, incorporates the latest green innovations. The Trent 1000 is the most fuel-efficient, least polluting and quietest aircraft engine ever produced.

A steady stream of contract wins this year by the Trent 1000 and other Rolls-Royce models has propelled the company's stock price:

Rolls-Royce doesn't disclose third-quarter revenue and earnings numbers. The company posted underlying profit for the six months to June 30 of 840 million pounds ($1.3 billion). Underlying revenue hit 7.3 billion pounds, a year-over-year increase of 27 percent.

With a trailing 12-month price-to-earnings ratio (P/E) of about 31, the stock is pricey compared to the trailing P/E of 12.6 for its industry of aerospace/defense. But the stock has superb long-term growth prospects, combined with blue-chip safety. It also should be noted that the aerospace/defense sector is undervalued, because of exaggerated fears of draconian budget cuts.

Indeed, Rolls-Royce is proving adept at bucking the US federal budget sequester to snag sizeable Pentagon contracts. In September, the company won two engine maintenance contracts from the US Navy—one for $50.7 million and another for $17 million.

On Nov. 8, the company announced that its overall business was trading in line with optimistic expectations, as aircraft engine demand remains robust.

Management said that it expected the company to post a 2013 pretax profit of between 1.36 billion to 1.89 billion pounds, or on average 1.74 billion pounds ($2.79 billion).

Guidance for all business segments was unchanged except in defense aerospace, where estimates for underlying profit were boosted from flat to modest growth. Rolls-Royce engines power nearly 2,800 fixed and rotary-wing aircraft currently in service with all branches of the US Armed Forces. Several overseas militaries also are regular Rolls-Royce clients.

With a solid balance sheet and a deserved reputation for making well-crafted products, this company should benefit from accelerating tailwinds in 2014—and weather any unexpected turbulence along the way.

John Persinos is editorial director of Personal Finance and its parent website, Investing Daily.

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China's New Reform Program: Will It Happen?

Philip Springer China last week announced a major program of economic and other changes that together have the potential to boost the nation's investment appeal. This is one of the most ambitious attempts at liberalizing China's economy since Deng Xiaoping opened up the country to global markets starting in the late 1970s.

Chinese stocks jumped on the news. The key now is if, when and how the reforms will occur.

The 20-page blueprint outlines 60 initiatives that would boost China's reliance on market forces and open more of the economy to private-sector and foreign competition. The agenda also would give the nation's people more social and economic freedom.

The most prominent item on the list calls for easing the longtime limit of one child for most families. By one estimate, the nationwide easing of family size restrictions could lead to one million to two million more births in China every year, in addition to approximately 15 million a year now.

Among the economic and financial reforms, market forces are to play a more decisive role. "The market should be left to decide the price of anything whose price can be decided by the market, and the government should not make any improper intervention," the program statement said. This is to apply particularly to prices of key resources such as water, oil, natural gas and electricity.

For foreign investors, a noteworthy component is that dividends from state-owned firms are supposed to increase under the plan. There's a specific goal: a 30 percent payout rate by 2020. State-owned firms now pay 5-15 percent of profits in dividends. While the government would get most of the money, ordinary shareholders should also benefit.

State-owned enterprises make up more than 80 percent of the value of Chinese-listed companies, and include many that trade in the US. The most prominent examples include PetroChina (NYSE: PTR), China Mobile Ltd. (NYSE: CHL), China Petroleum & Chemical (NYSE: SNP), China Life Insurance Co. (NYSE: LFC), China Telecom Corp Ltd. (NYSE: CHA) and China National Offshore Oil (CNOOC) Ltd. (NYSE: CEO).

A consumer reform of note is deregulated interest rates. There currently is an interest-rate ceiling on bank deposits and loans that effectively subsidizes banks and borrowers at the expense of savers. In theory, this should result in better lending controls and higher savings yields. Also called for is establishment of deposit insurance, similar to the FDIC in the US.

In addition, private investors are to be allowed to set up banks. And the government is supposed to make efforts to improve the country's bankruptcy system.

The program also targets greater property rights, particularly in rural areas. Farmers would be able to more freely rent, sell and mortgage their land, with greater protection against government confiscation.

Xi Jinping became chairman of the Communist Party a year ago and president of the People's Republic of China eight months ago. He is said to have led the group drafting and finalizing the plan. This is in sharp contrast with previous programs, whose development typically has been delegated to the prime minister and others.

Xi's active leadership is seen as a way to give the program increased credibility while strengthening his leadership position. "He's not hanging out a sheep's head and selling dog meat," said one expert, using a popular Chinese expression that means selling bogus goods. "He's hung out a dog's head and is selling dog meat."

A sheep's head and sheep meat likely would be preferable, even in China. However, execution is the key. Recent efforts to make big structural adjustments in the economy generally have fallen far short. In 2007, Premier Wen Jiabao called China's economy "unstable, unbalanced, uncoordinated and unsustainable."

Yet China's ambitious five-year plans in 2006 and 2011 accomplished little. And because of the global financial crisis, Wen Jiabao introduced a huge economic stimulus plan with heavy investments in real estate and infrastructure, which have exacerbated the problems.

The new reform document lays out few timetables. And implementation is largely up to China's huge bureaucracy. While the Communist Party sets overall policy direction, the central and provincial government agencies will handle the reform details and operation. As in many government bureaucracies, China's have many conflicting interests, rivalries and ties to interest groups that benefit from the status quo.

China experts believe that while the leaders want to improve the economy, their ultimate objective is to strengthen the Communist Party's position and traditional one-party rule.

This is why the party simultaneously is tightening political ideology, with a crackdown on dissent, including stricter control of the Internet.

This article originally appeared in the Mind Over Markets column. Never miss an issue. Sign up to receive Mind Over Markets by email.

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Sometimes Talk Is All It Takes

Ari Charney

Last week, we argued that the Reserve Bank of Australia (RBA) will have to cut rates further to force the Australian dollar lower. But it turns out that, like other central banks, the RBA has another powerful tool at its disposal: jawboning.

In recent weeks, RBA Governor Glenn Stevens has gone from characterizing the level of the exchange rate as "uncomfortably high" to noting "that foreign-exchange intervention can, judiciously used in the right circumstances, be effective and useful."

That latter observation, which was offered in a speech before the Australian Business Economists' annual dinner on Nov. 21, has already helped push the currency down by more than a cent, which may not seem like much, but is a substantial short-term move in the arena of currency trading.

According to the Wall Street Journal, in the decades since Australia shifted to a floating exchange rate in 1983, such a currency intervention has essentially been verboten. So it's a noteworthy shift for policymakers to announce publicly that this approach could be worth considering.

Westpac senior currency strategist Sean Callow says the RBA's latest jawboning campaign began in earnest on Oct. 29, when the currency was trading near USD0.95. After having fallen as low as USD0.89 in late August, the Aussie rose sharply after the Fed opted to defer its widely expected September taper until a later juncture.

The currency climbed as high as USD0.97 in late October, with three cascades since then, the latest of which has taken the currency from USD0.943, on Nov. 19, to USD0.916 (at time of writing). The Aussie is currently down about 13.6 percent from its year-to-date high in early January.

We had actually discounted the RBA's ability to achieve meaningful depreciation through public pronouncements because the concrete actions of its rate-cutting cycle had already failed to do the same. It wasn't until the US Federal Reserve began talking about pulling back on its extraordinary easing in early May that the Aussie finally began plummeting. If actual rate cuts couldn't undermine the currency, then what good would mere chatter be?

But sometimes it's all about psychology. And the selloff in the Aussie since the late spring may have reset traders' attitudes toward the currency, which prior to that point had risen as much as 83 percent from its low during the Global Financial Crisis, while trading above parity with the US dollar for the better part of two years.

That relative strength was causing significant pain for Australian firms that compete in the global markets. We've read the transcripts of numerous earnings calls where management teams bemoaned the effects of the strong currency on overseas sales. And with the resource boom fading and policymakers hoping to find another sector that can help boost the country's slowing economy, it's crucial for companies that are looking to foreign markets for growth to have a currency edge.

Of course, as we've also noted recently, short-term movements in the Aussie have been increasingly correlated with traders' expectations regarding Fed policy. On that front, the RBA once again received some help from the Fed. The minutes from the Fed's Oct. 29-30 meeting of its Federal Open Market Committee, which were released on Nov. 20, showed that policymakers expect labor market conditions to continue improving, which would "warrant trimming the pace of purchases in coming months."

Still, this isn't actually a timetable, and any taper is dependent on an improvement in the data. But traders seem to interpret such statements as if they're the former, rather than the latter. Regardless, in the short term, such expectations have helped the RBA achieve its policy end, even if yet another deferred taper causes the exchange rate to temporarily spike again. By that point, however, the RBA may have cut rates once more, which would presumably limit the fallout from another Fed flinch.

This article originally appeared in the Down Under Digest column. Never miss an issue. Sign up to receive Down Under Digest by email.

T. Boone Pickens is Investing Again. So Should You

In the last natural gas boom in 2002-2007, T. Boone Pickens pocketed $1.4 billion. Now he's convinced that natural gas will knock other fuels out of the market … and diesel will be the first to go. Truckers are dumping it and switching to this cleaner, cheaper, all-American gas. You could turn $10,000 into a whopping …

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