Rolls-Royce (LSE:RR) stock gained more than 6% on Tuesday in what was a strong session for the FTSE 100. The engineering giant soared on speculation that the business may benefit from a boost in defence orders. The share price has been dragged down in recent years by the lagging, pandemic-hit civil aviation sector.
The stock started downwards on Wednesday morning, but I’m expecting Rolls-Royce to make gains in the coming months. Here’s why!
Defence sector boost
Defence is Rolls-Royce’s second largest business segment. There has been renewed focus on defence and security through NATO nations and its partners, notably since Russia’s invasion of Ukraine. However, until Tuesday, this appeared to have little impact on the Rolls-Royce share price.
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In fact, in February, when Russia built up troop numbers around Ukraine, shares in British defence and security giant BAE Systems soared. However, shares in Rolls-Royce actually dipped amid concerns that its civil aviation business — the company’s largest segment — would be impacted by reduced air travel.
Last year, it generated £4.5bn from its civil aerospace division, £3.3bn from defence, and £2.8bn from power systems operations.
Civil aviation returning to normal
Civil aviation is returning to pre-pandemic levels despite the travel chaos we’re currently experiencing in the UK. This chaos is largely due to inadequate staffing (I experienced Heathrow’s staffing shortage first-hand yesterday).
A number of airlines are flying near to pre-pandemic capacity at the moment. However, the important data will come at the end of Q2 and Q3. This will tell us how close the civil aviation industry is to fully recovering.
Morgan Stanley recently suggested that the sector was much closer to being fully recovered than the market may have priced in. “Parsing the recent Civil Aerospace investor day suggests an earnings recovery is much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery,” it said.
The bank upgraded Rolls-Royce shares to ‘overweight‘ in June, adding that it was “the clearest example of mispricing” in its coverage.
Debt reduction
Without positive free cash flow (FCF), Rolls-Royce will struggle to develop its offer. The company took on considerable debt during the pandemic. It needs to reduce its indebtedness to enhance profitability and invest in the future.
The engineering giant is hoping to raise some £2bn by selling off business units to fund debt repayments. Obviously, selling business units, along with reducing the staff size by 9,000, is likely to hinder revenue-generating capacity in the long run.
A quality brand
I already own Rolls-Royce shares, but I’d buy more at today’s price and hold them for the long run. The reason is that Rolls-Royce operates in sectors where there’s a premium on quality.
Aviation, defence, and nuclear power, are sectors where maintaining high standards are of the upmost importance. And I think that means newcomers, potentially from developing nations, will struggle to take market share away from Rolls and its American peers in the long run.
