Rolls-Royce, once a laggard in most DIY investor portfolios, is now ranking around the top of brokers’ most popular stocks. It was just over a year ago that new chief executive Tufan Erginbilgic started at the business, claiming it had been “grossly mismanaged” for years. Since he took charge, the shares have almost quadrupled in value — but can it last?
The FTSE 100 company’s largest business is in civil aerospace, where it manufactures engines for large commercial aircrafts and regional jets. Most of the profits in this segment come not from sales, but the money it makes from the long-term contracts to service the engines — this means the longer they are in use, the more money Rolls makes. The pandemic, when planes were grounded, proved disastrous, and resulted in thousands of job losses. Technical problems with its Trent 1000 engines added salt to the wound.
But the shares have roared back in the past 12 months, thanks in no small part to the success of Erginbilgic’s turnaround plan, which doubled profit margins in just one year and led the company to record cash inflows.
Erginbilgic, a former BP executive who joined the company after the almost eight-year tenure of Warren East, has laid out a vision for 2027: operating profits of up to £2.8 billion, profit margins as high as 15 per cent and annual net cash inflows as high as £3.1 billion.
Much of this hinges on its civil aerospace division, which primarily makes engines for the Airbus A350 and Boeing 787. One reason why margins here were historically weak is that the company cut prices aggressively on new engines in a bid to win market share. Now management is prioritising the bottom line, with margins up from 3 per cent in 2022 to 12 per cent in 2023. There is still some catch up ahead given that rivals such as Safran and General Electric make margins that are closer to 20 per cent in this area, though they specialise in higher margin business for narrow body planes.
A rebound in passenger flights has also been a big boost for Rolls, and there could still be more here to gain given that long haul routes and Chinese international traffic still have some way to recover. The company thinks long-haul flying this year could be a tenth higher than pre-pandemic levels.
The market often overlooks Rolls’ small new markets business — but there is much here that looks promising too, not least its development of small modular reactors. Rolls has the potential to lead the way in small nuclear power plants in the UK, where the national target is to produce 25 per cent of electricity from nuclear by 2050, up from around 15 per cent currently. Rolls-Royce has already received £210 million of government grants for its projects.
Long-term holders of Rolls may miss the dividend, which was last paid in 2019. While there are no formal plans to reinstate it, this looks possible given net debt dropped from £3.3 billion to £2 billion in its last financial year, and two credit agencies now rate its debt as investment grade. Analysts at Jefferies reckon shareholder payouts could materialise as early as its half year results in August.
Rolls’ turnaround has impressed the city, and its rally last year means the stock is back in line with peers. But the company must prove to investors that it can maintain the balancing act of reducing costs, rising prices and not harming operations. The shares trade at a forward price to earnings multiple of 26, compared with Safran at 30. For now, Erginbilgic’s success appears to have created a halo effect around the shares and, while Rolls has made impressive progress over the past year, its rising price leaves less and less room for error.
Advice Hold
Why Looks fairly priced after significant improvements in profits and margins
Mercantile Investment Trust
This fund belongs to the City’s club of old investment companies, dating its history back to 1884. Today Mercantile Investment Trust, which is managed by JP Morgan Asset Management, focuses on finding quality British businesses outside of the FTSE 100.
That being said, this is not a trust that invests in particularly small businesses. Around 87 per cent of its portfolio is in companies worth between £1 billion to £10 billion. Its top holdings include the house builder Bellway, followed by private equity firms Intermediate Capital and 3i Group.
Mercantile’s managers Guy Anderson and Anthony Lynch look for quality businesses that can deliver long-term growth, and a sharp focus on sustainable cash flows has meant they have increased dividends every year in the last decade. Overall, the portfolio has a free cash flow yield of 7 per cent and a return on invested capital of 14.5 per cent, according to analysis by the broker Winterflood.
The trust posted a respectable performance in its financial year ended in January, with a net asset value return of 5.4 per cent, compared with a 9 per cent drop the previous year. Over the past five and 10 years it has delivered 34 per cent and 89 per cent respectively, compared with a return in the FTSE All Share, its benchmark, of 18 per cent and 56 per cent.
Mercantile trades at a 12 per cent discount to its net asset value, compared with a five year average of 9 per cent, and yields a reasonable 3.4 per cent, the second highest in its sector, behind the Schroder UK Mid Cap fund. The trust also charges a 0.45 per cent fee on its market cap, which is relatively low and gives the managers further incentive to narrow the discount.
The managers are confident in the UK market, reflected by a historically high gearing at 14.8 per cent. This may be well-placed given the FTSE 100 reached a record high this week (though not in dollar or euro terms). But whether this enthusiasm can extend to Britain’s mid-cap stocks remains to be seen.
Advice Hold
Why Good record but unclear outlook for UK mid caps
