The share price of London-listed engineering and aerospace company Rolls-Royce has had a strong 2023 so far, up almost 50% for the year-to-date. From its most recent low of 66.24p-a-share set on October 12 last year, Rolls’ valuation has gained a spectacular 122%.
But despite the stock’s impressive recent momentum, Rolls-Royce is worth a lot less than it has been in the relatively recent past. A decade ago, Rolls-Royce shares traded at over 425p compared to today’s 147p. The most recent high point, set in August 2018 saw the shares trading at 375p.
Rolls-Royce was hit hard by the Covid-19 pandemic
A lot has happened since then. The Rolls-Royce share price hit a 17-year low in October 2020 at the height of the Covid-19 pandemic in Europe after the engineering company announced it expected a £4 billion loss for the year. A prediction that proved accurate. The huge losses over the pandemic period were the result of commercial airlines grounding fleets for months and then only slowly returning to pre-Covid schedules this year.
In 2019, Rolls-Royce made over 50% of its revenues from its civil aviation business. Much of those civil aviation revenues are reliant on contracts to service its engines, which are used by Airbus, Boeing, Gulfstream and Dreamliner jets.
With these aircraft either grounded or flying far fewer routes during the pandemic period, and contracts tied to servicing based on the number of airmiles flown by engines, Rolls haemorrhaged cash.
Source: SeekingAlpha
In its efforts to come out of the other end of the crisis solvent, the company cut 9000 jobs and raised £5 billion. The cash was brought in through a combination of a rights issue that tapped existing investors for £2 billion, loan facilities and corporate debt. As a result, the company’s net debt stood at £5.2 billion at the end of 2021.
2022 marked the beginning of the Rolls-Royce recovery
From the depths of those pandemic lows, 2022 proved a strong one for Rolls-Royce investors with the company the best performer among the FTSE 100. That surge in the company’s valuation has continued this year and, to date, it is again the London benchmark index’s strongest performer for 2023.
A post-pandemic leap in the number of air miles flown by Rolls Royce jet engines used in civil aviation, a trend expected to continue this year and next, boosted cash flow. The outlook for Rolls’ defence business is also currently very bright as Western governments including the UK ramp up defence spending in the wake of Russia’s invasion of Ukraine early last year.
Rolls-Royce share price threats
There are, however, a handful of threats to the continued upwards movement of the Rolls-Royce valuation. Firstly, after recent gains the stock does look expensive with a price-to-earnings ratio of around 75, translating into an earnings yield of just 1.3%.
However, as we’ll cover later, the Rolls-Royce share price looks far more attractive on the basis of expected 2023 earnings, which are expected to leap.
Investors are putting their faith in increased defence spending and new business units such as nuclear boosting revenues in future years to justify today’s valuation.
Another downside to Rolls-Royce today is a lack of dividends. Shareholder payouts were cancelled during the Covid pandemic and with the need to continue to boost cash flow and pay down debt which is still high at £3.3 billion, it’s unlikely they will be imminently reinstated.
Will nuclear provide atomic-powered returns for Rolls-Royce shareholders?
Rolls is placing a lot of faith in its investment in developing next-generation nuclear reactors.
These small modular reactors, or SMRs, will have a capacity of 470M. That’s enough electricity to power a city around the size of Leeds, Sheffield or Newcastle-upon-Tyne. However, these SMRs have far smaller capacity than traditional nuclear power plants. For example, Hinkley Point C will have a capacity of 3200WM, almost seven times that of a Rolls SMR.
But SMRs also cost a lot less than traditional power plants. Hinkley Point C was expected to cost £18 billion to build but is 10 years behind schedule and the final bill is expected to come in at over £30 billion. That’s around 15 times the £2 billion that Rolls plans to sell its SMRs for.
The smaller capacity of SMRs and the fact they are modular and much easier and quicker to build means they are far more predictable. Their smaller size also makes them a lot safer and spreads risk. One SMR not producing electricity for a period is a much smaller problem than a traditional nuclear plant going offline. A grid powered by multiple SMRs is also an attractive proposition from a national security point of view.
SMRs have an expected 60-year lifespan and take around four years to build. At a £2 billion price tag, Rolls is confident in market demand and would only need to sell seven units a year to equal the company’s total 2022 revenues. The UK government is partnering with Rolls-Royce to deliver the first SMR and last year committed £210 million to the development programme.
Plenty of other European and international governments see nuclear as a key part of their future energy mix and France already generates 75% of its electricity from nuclear with countries such as Belgium and Slovakia also relying on nuclear for a majority of power. Many existing plants are, however, ageing, and SMR technology is arriving at a convenient time to potentially play a major role in their phase-out over the next couple of decades.
However, with the Rolls’ first SMR not expected to be fully operational until 2030, it may be half a decade or more before the new business unit has a significant impact on the company’s revenues and valuation. Many potential customers are likely to hold off making orders for Rolls SMRs until they’ve seen them operational.
There are also no guarantees the nuclear business will prove as successful as the company and many analysts hope, making it a risky foundation on which to base investment in Rolls-Royce today.
Does Rolls still have short to medium-term upside after recent gains?
A bet on the future prospects of Rolls-Royce based on the potential of the nuclear power business could be one some investors with patience and long term investment timelines are ready to make. But is there likely to be much share price upside based on the ongoing recovery of the current civil aviation and defence markets? Or has that already been largely priced into the company’s current valuation?
I’ve already mentioned that Rolls looks expensive at its current valuation on a backwards-looking price-to-earnings ratio. But the picture is very different on a forward-looking basis. Analysts are predicting Rolls’s annual earnings to leap 156% this year compared to last year. If that turns out to be the case, the current forward price-to-earnings growth (PEG) ratio of just 0.2 makes the shares look cheap. A PEG of under 1 is seen as an indicator of relative value.
Civil aviation still accounts for around 45% of Rolls revenues and the sector looks healthy again with total passenger demand tipped to show 3% growth this year. The company is also expected to generate its best free cash flow levels in years in 2023, with anaysts forecasting between £800 million and £1 billion. If that eventuates the presumption will be most of it will be used to pay down debt but there is a chance some could be used to reinstate a small dividend that would be expected to grow in coming years.
The company’s Power Systems unit, which contributed 43% of operating profit last year from revenue contribution of 25%, is in a good place with an order book that grew double digits in the past 12 months and the promise of more to come.
Defence will make perhaps the biggest contribution to near term valuation growth if global defence spending continues to rise over the next few years as expected.
Risks remain but Rolls-Royce could be both an attractive near and long term investment
An investment in Rolls-Royce today would carry a reasonable amount of risk with the company still in a delicate stage of its recovery. Any setbacks would be expected to be punished by a market that wants to see consistency in the engineering company’s financial performance after a nightmare last decade.
However, despite the extent of recent gains, there could be some solid upside left in the Rolls share price if positive news continues to flow. And over the next decade, the new nuclear business could take much of the strain off the current business units of civil aviation, defence and power systems and add considerably to the company’s order book.
A return to the highs of 2013 still looks a long way off but investors are showing optimism in the company’s potential to eventually complete a long recovery.
