Rolls-Royce (LSE:RR) shares are down 14% over the past year, in spite of a recent rally. In fact, the turn-of-the-year rally has been considerable — the stock is up 21% over the past month.
But I think it could go further. And there are several reasons for this.
China reopens
Late last year, Rolls said that large Engine Flying Hours (EFHs) were around 65% of pre-pandemic levels in the four months to the end of October. This highlights the ongoing challenges for the engineering giant, because engine flying hours have been the main income generator for the firm.
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But China’s reopening should provide a major boost, especially as long-haul flying hours have lagged. In China, wide-body planes with two aisles and Rolls-Royce engines are often used for short-haul routes. But in 2022, flying hours remained around 30% of pre-pandemic levels.
With China’s economy reopening, internal and international flying hours will increase. In turn, this will boost Rolls-Royce revenue in 2023.
New aircraft orders
An improving environment for civil aviation has contributed to an improving order book for new engines. Airlines like Air India, United, and American placed sizeable orders for new jets in 2022.
One of the most recent orders order came from Air India, which plans to increase its fleet by 500 planes. Not all of these aircraft will use Rolls-Royce engines, but it’s indicative of the positive trends within the industry.
A factor contributing to this is that some 13,700 aircraft were mothballed during the pandemic. This was seen as a necessary move in the short term, but as demand comes back, new supply is needed.
Geopolitics
The geopolitical environment is tense. There’s a war in Europe and there are concerns that China could once again push its claims over Taiwan.
In this environment, I expect to see the increasing focus on national defence translate into more orders for engines to power military vehicles, as well as growth in other areas of Rolls-Royce’s defence segment.
Several of its engine products serve both the civilian and military market. For example, the Trent 700 engine is used to power the RAF Voyager and the Airbus A330 — one is a military variant of the other.
And in December, Rolls received a multi-billion dollar uplift when it was announced that the US awarded the contract for its Future Long-Range Assault Aircraft, FLRAA, to Textron‘s V-280 Valor project. Rolls-Royce will deliver two AE 1107F engines to power each V-280 Valor. Throughout the project’s lifecycle, the total anticipated demand is 5,000 engines.
My position
I already hold Rolls-Royce shares and I won’t hesitate to buy more. A discounted cash flow model with an exit at 10 years suggests Rolls is undervalued by around 45%. It could be one of the big winners in 2023.
