2023 was an outstanding year for Rolls-Royce (LSE: RR). Over the course of just 12 months, Rolls-Royce shares more than tripled in price.
I owned the shares and sold them last year. I currently have no plans to add them back into my portfolio. Here, I explain three main reasons why.
Solid performance
Before I do that though, I think it is worth considering the bull case for Rolls-Royce shares.
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After all, the valuation of a FTSE 100 company does not usually triple in one year without some cause. Over five years, admittedly, the gain has been a far more modest 6%.
Booming civil aviation demand has helped boost revenues and profitability at the firm. Ongoing strong demand could see that trend continue.
A new chief executive has taken a vigorous approach to reshaping the company and cutting costs. The City has cheered what that could mean for profits.
Even after the price rise, the market capitalisation of around £25bn is only around 10 times the company’s medium term target of annul operating profits of £2.5bn-£2.8bn.
Reason 1: execution risks
One concern that keeps me back from buying the shares is the price factors in high expectations for commercial performance. But making a plan is one thing – implementing it successfully is another.
Any period of significant corporate change can bring risks from weakened employee morale to overreach by the sales team hurting long-term profit margins.
Such risks are not specific to Rolls-Royce. But the firm’s ambitious turnaround plan has set investors’ expectations high. Time will tell whether management can deliver on its big promises.
Reason 2: uncertain demand outlook
The longer term issue that concerned me about Rolls-Royce shares even when I owned them was the nature of its core industry.
On one hand, having limited competition and selling a complex, expensive product that needs to be serviced regularly is the commercial model of business school dreams.
On the other though, I do not like the fact that engine sales and servicing can both suddenly be hit dramatically by factors outside the firm’s control.
We saw this clearly during the pandemic when at one point Rolls-Royce shares traded for just one-seventh of their recent highs.
But we also saw it with the 2010 Icelandic volcano eruption, the 2001 US terrorist attacks and other such events. That sort of systemic risk to customer demand puts me off the shares.
Reason 3: challenging valuation
Having said that, there are still things I like about the company. But even if I was looking to buy Rolls-Royce shares, the current price tag alone would put me off.
Although the current price is only around 10 times projected medium-term operating earnings, I think the price-to-earnings ratio needs to be handled with caution. The earnings are only a projection. Costs like debt servicing can mean there is a significant difference between operating earnings and reported earnings.
Historically, the company’s profitability has moved around a lot and I think that could continue to be the case in the absence of clear plans for smoother profit delivery.
To me, the current price of Rolls-Royce shares already factors in expectations success. So I fear it offers me little potential opportunity even if the business performs as hoped.
