A 12-month share price gain of more than 230 per cent is not unheard of in UK markets, but it’s more common among smaller, racier technology stocks than a FTSE 100 heavyweight such as Rolls-Royce (RR.).
The Derbyshire-based engine maker has experienced an even more rapid appreciation than US chipmaker Nvidia (up 200 per cent), which isn’t bad for a company that chief executive Tufan Erginbilgic described as a “burning platform” within weeks of taking charge in January.
The use of this phrase is not new (former Nokia boss Stephen Elop deployed it 12 years ago) and in Rolls-Royce’s case seemed unjustified.
Although it had accumulated nearly £9bn in pre-tax losses in its preceding five years, a recovery was already under way. The company makes most of its revenue (45 per cent last year) from its civil aerospace arm – specifically, from the amount of time its large engines spend in the air. Given the massive cuts to overheads the company had embarked upon at the height of the pandemic – it announced 9,000 job cuts, or a fifth of its workforce – there were always going to be operational leverage benefits as aviation markets recovered. Indeed, the first big leg-up in Rolls-Royce’s share price came in February, when it reported positive free cash flow of £500mn for 2022 – a £2bn turnaround on the previous year, as engine flying hours increased by 35 per cent.
Another big boost came from China’s reopening of its airspace in January. Rolls-Royce’s engines are fitted to wide-bodied jets used for long-haul flights, and the recovery of these had lagged the rest of the market given a slow recovery in Asia-Pacific traffic. Yet aviation trade body the International Air Transport Association (IATA) reported passenger traffic on Asia-Pacific airlines was up 80.3 per cent year on year in October.
This has fed into a much-improved performance, with Rolls-Royce reversing a half-year pre-tax loss of £1.75bn in 2022 into a profit of £1.42bn. Full-year guidance was also upgraded, with free cash flow forecast to nearly double to £900mn-£1bn.
This isn’t to suggest that the share price rise has nothing to do with Erginbilgic, though. The new boss has completed a wide-ranging review of the business, revealing plans to cut a further 2,000-2,500 roles by the end of 2025. Rolls-Royce is also centralising some functions to eliminate duplication and, in the case of procurement, increase scale.
Rolls-Royce had a total cash cost to gross margin ratio of 0.8 last year, which is “around twice the best-in-class level for a business like ours”, Erginbilgic said at a capital markets day in late November.
The company is targeting £400mn-£500mn of “sustainable” annual savings as part of a plan to boost operating income from last year’s £652mn to between £2.5bn-£2.8bn by 2027. It plans to increase operating margins from 5.1 per cent to 13-15 per cent, which would equal or better most peers, Erginbilgic said.
Engine thrust
To achieve this, the heavy lifting needs to be done by the civil aerospace arm. Rolls-Royce’s large engine flying hours are now back to 2019 levels, and it expects them to increase by 20-30 per cent from there on the back of continued market recovery and fleet expansion. It is also focusing on making engines more durable, meaning they spend longer in the air and generate more profit. On top of this, it is planning to re-enter the market for narrowbody aircraft, which is likely to make up 80 per cent of demand over the next 20 years, according to planemaker Airbus (FR:AIR).
The new targets led to a series of broker upgrades that provided fresh impetus to Rolls-Royce’s shares. Deutsche Bank’s Christophe Menard lifted its target price on the company’s shares by 29 per cent to 400p, arguing that the company’s medium-term guidance on annual free cash flow generation of £2.9bn-£3.1bn was ahead even of its own “bullish” expectations.
Morningstar’s Loredana Muharremi also lifted her target price for the company, but only to 289p, arguing that the shares were fairly valued and that the company had a narrow economic moat. Others also think that lofty expectations are priced in, with the shares trading just 6 per cent below the FactSet consensus broker price target of 307p.
One momentum driver would be a restoration of its investment-grade rating, which it lost three years ago. Ratings agency Moody’s said earlier this month that, although it had “seen the first signs of broad-based improvements in operational and financial performance” over the past 18 months, the company still needs to maintain large cash and liquidity buffers to meet the potential costs of servicing its engines under long-term service agreements with clients. Rolls-Royce valued current contract liabilities at £8bn as of 30 June, and its total liabilities were still £5bn higher than its total assets. Until some of this load is shed, any further material gains in altitude for the company’s share price look unlikely.
