To the surprise of many investors, Rolls-Royce (LSE:RR.) shares have stolen the show of late. The engineering giant has seen its valuation almost triple in the last 12 months, as sales, earnings and cash flow growth all land in double-digit territory for the first time in years.
But while optimism is driving significant momentum, some signs suggest that a peak could be near. With that in mind, let’s take a closer look at what’s going on under the surface.
The recovery of civil aerospace
Being such a vast enterprise, there are a lot of factors influencing the Rolls-Royce share price. Even after the group sold off billions of pounds worth of assets and operations to pay down debt, the company still has its fingers in several pies. This includes defence, energy and, of course, aerospace.
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Building and servicing aircraft engines used for long-haul flights is currently the firm’s largest source of revenue. This dependency proved seriously problematic when the pandemic came along and decimated demand, bubbling all of the group’s underlying financial problems to the surface.
However, Covid-19 is no longer posing a massive threat. And while the aerospace sector hasn’t fully recovered, large engine flying hours now stand at 83% of pre-pandemic levels. That’s up from 60% a year ago. And this double-digit jump enabled the group’s Civil Aerospace division to expand sales by 39.2%
At £3.3bn, sales are still short roughly £700m versus pre-pandemic levels. But once the aerospace sector fully recovers, this gap should close promptly. And with operating margins already exceeding 2019 levels significantly, Rolls-Royce could end up in a prime position.
However, this is where performance may start to lose altitude.
Recovery versus organic growth
Double-digit growth is a welcome sight, especially for a firm that’s struggled to deliver such impressive numbers for years. However, investors must investigate what’s actually driving it.
In 2023, the company is riding the recovery tailwinds of the travel industry. But these will eventually stop blowing, at which point organic growth will need to take the reins. There are some signs of organic growth in its Power Systems and Defence segments, with new contracts being signed and customer price hikes.
However, the jury is still out regarding the Civil Aerospace division. There’s a chance that growth will return to a slow crawl in line with the long-haul travel market over the next couple of years. And since this segment is currently responsible for around 47% of the top line, that could offset the progress made in the other segments.
Diversification into new markets like nuclear power could alleviate this sector concentration risk over time. However, I’m sceptical that enough progress will be made before the momentum and excitement surrounding the group’s comeback starts to fizzle out.
After seeing the drastic action taken by management to end the turbulence, I’m cautiously optimistic that Rolls-Royce has a bright future. But the journey upwards isn’t likely to be a straight line.
So I have a hunch that the stock could end up pulling back some of its recent gains until the company can prove itself outside of a recovery. That’s why it’s staying on my watchlist for now.
