Rolls-Royce (LSE:RR) shares are still down 40% over the course of the year, but they’ve surged in recent months. In fact, the stock is up 15% over the past month, outpacing much of the FTSE 100.
But I reckon its got further to rise!
Returning dividends?
Rolls-Royce had been barred from paying dividends until 2023 under the terms of loans in took out during the pandemic. But the company has been working hard to pay off its debts, and completed a £2bn sell-off of business units in September. The funds were used to pay down nearer-term debt. Rolls still has £4bn in debt obligations between 2024-2028, but this is all on fixed-interest rate terms.
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It’s unclear whether Rolls will be able to pay its shareholders dividends next year, but it’s certainly more likely. There’s a second reason why it hasn’t been paying dividends, and that’s because it’s been losing money. But Rolls appears to be on the path to profitability.
Tailwinds
Civil aviation is Rolls-Royce’s largest business segment. But during the pandemic, this revenue stream was severely cut. However, this business segment is improving. The group recently announced that large Engine Flying Hours (EFHs) are around 65% of pre-pandemic levels in the four months to the end of October.
Highlighting the year-on-year improvement, Rolls said there had been a 36% growth in year-to-date engine hours compared to 2021. However, the group also noted an uneven global recovery in travel, with the US and Europe rebounding well, but China and Asia lagging, due to ongoing Covid measures. Many planes with Rolls engines serve long-haul routes.
Further boosts
Rolls has two other business segments, power systems and defence. The power systems division has seen orders grow 53% to £2.1bn over 12 months. The sector provided about 25% of last year’s revenue and has recently won contracts to provide engines for UK armoured vehicles and engine generators for German naval frigates.
The group has highlighted “robust” demand in the defence sector but expects “no material benefit” from increases in government defence budgets this year. That’s because the defence tech it develops traditionally has a much longer life cycle. However, over the longer run, I’d expected the renewed emphasis on defence around Europe to enhance demand further.
Possible downsides?
Rolls is currently trading closer to its 52-week low (64p) than its 52-week high (150p). There has been plenty of volatility here. The current share price reflects concerns about the impact of debt on the firm’s profitability going forward, as well as more general worries about the recovery of the aviation industry.
Despite this, and broadly echoing the sentiments of Morgan Stanley earlier in the year, I think the recovery is much further down the line than the share price suggests. Two of the three business units are now at 2019 levels, or outperforming.
A good opportunity
I already own Rolls-Royce shares, and they haven’t been good to me. But trading around 85p, I’m buying more as I’m expecting the share price to continue its gains. Pandemic-era debt has been reduced, operations are improving and the firm operates in areas of the market — aviation, defence, power systems — with high barriers to entry.
