To say I’m glad I haven’t been a Rolls-Royce (LSE: RR.) shareholder over the past half-decade would be an understatement. Under relentless selling pressure, Rolls-Royce shares underperformed the broader market by a considerable margin.
However, the FTSE 100 aerospace manufacturer’s share price has rocketed since mid-October. Is the bottom finally in or are further drawdowns on the horizon?
Here’s my take.
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A positive trading update
Last week, investors reacted positively to a trading update issued by Rolls-Royce.
The continued recovery in large engine flying hours, record order intake in Power Systems and a resilience in the Defence business give us confidence in the future.
Warren East, Rolls-Royce CEO
Rolls-Royce’s primary business is aero-engine manufacturing. Accordingly, robust civil aviation demand is critical to ensuring a healthy cash flow. News that large engine flying hours reached 65% of 2019 levels in the four months to the end of October (up 36% year to date) is a welcome development.
The firm also announced big wins for its defence arm, namely $1.8bn in contract renewals and repricing for the next five years to support engines in service. This is important, given defence generated 31% of the group’s revenue last year.
Rolls-Royce anticipates there will be “no material benefit from the increase in government defence budgets in the near term due to our long product cycle”. Nonetheless, with no peaceful resolution in sight to the Russo-Ukrainian war, elevated geopolitical uncertainty seems here to stay. This should provide some long-term support for the Rolls-Royce share price in my view.
The Power Systems division looks particularly healthy. Responsible for 25% of last year’s revenue, the company recently trumpeted a record order intake in 2022. This was driven by sales of mtu armoured vehicle engines and navy frigate gensets to the UK and Germany respectively.
Big risks remain
Although the trading update strengthens the bull case, I can still find reasons to be bearish.
Last year, Rolls-Royce anticipated large engine flying hours would recover to 80% of 2019 levels in 2022. While the trajectory is positive, the latest trading update suggests the company will fall short of its previous forecast. China’s ‘zero-Covid’ policy remains a significant headwind to recovery in Asian aviation. I think it’s too early to get excited about a full-blown recovery in the sector.
I’m also disappointed to see the business reiterate its FY22 guidance, citing the inflationary environment. Revenue growth is anticipated to be a low-to-mid single digit percentage, the operating profit margin broadly unchanged year on year, and free cash flow will be “modestly positive“. These are hardly eye-catching figures.
Would I buy Rolls-Royce shares?
Despite the risks, I’m more bullish on Rolls-Royce shares than I have been for a while. The trading update is a huge step in the right direction for a company that was, until recently, incurring heavy losses and haemorrhaging cash. I’m going to stick my neck out and say I believe it’s likely that a short-term bottom could be in.
If I had some spare cash, I’d enter a small position here to capitalise on any upside potential while remaining wary of the fact that the business still has a long way to go to return to full health.
