Can a recovery in civil aviation help Rolls-Royce shares take flight?

The Rolls-Royce share price is currently trading around its lowest level for the past year, but some recent good news has got analysts thinking that the stock could improve its performance in the coming months. Its most recent trading update showed that the company was taking off again after the pandemic grounded the aviation industry.

A recovery in aviation meant Rolls-Royce [RR.L] saw flying hours increase by 42% in the first four months of the year compared with the same period in 2021.

In the medium term, the jet engine maker expects civil aerospace revenue to grow by a low double-digit percentage, while cashflow is expected to comfortably” exceed operating profit with operating margin percentage forecast to be in the high single digits.

We are confident that we have positioned the business to achieve positive profit and cash this year, driven by the benefits of our cost reductions and increased engine flying hours,” CEO Warren East said in a statement.

Jefferies analyst Chloe Lemarie described the positive trading update as uneventful, which we welcome,” according to a note seen by Shares Magazine.

Since the update on 12 May, investors have gradually started flying back to the stock, which had set its 52-week low of 77.86p two days prior. The Rolls-Royce share price closed on 6 July at 82p — well below the 52-week high of 161.91p recorded on 10 December last year. Its currently trading at its lowest level in over 18 months.

Reason for the share price to take flight

With civil aviation expected to continue picking up throughout the summer and the rest of the year, Morgan Stanley believes that the Rolls-Royce stock is mis-priced at its current level. Even though the price target was cut from 132p to 118p in mid-June, the analysts upgraded their rating to ‘overweight’.

“Parsing the recent Civil Aerospace investor day [on 13 May] 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,” the Morgan Stanley analysts wrote in their note.

The defence segment also performed strongly in the first four months of the year. While the latter makes up only a small part of Rolls-Royce’s overall revenue, a strong order book and long-term defence contracts provide reliable future revenue. Defence customers are not immediately exposed to individual geopolitical events,” noted the company. The order backlog also means it’s well positioned to deal with inflationary and supply chain headwinds.

It’s a diamond in the rough, and being that it supports defence departments around the world, some level of income for the company is basically guaranteed, particularly in the current climate,” wrote Hargreaves Lansdown analysts following the trading update.

Some turbulence remains

While operating margins in the defence business are expected to be lower in 2022 compared to 2021, the completion of the sale of ITP Aero during the first half of 2022 is expected to have generated £2bn. This money will be used to repay debt.

Barring any significant disruptions, the group’s on track to be free cash positive this year. This should help debt make its way lower and would go a long way in restoring our faith in Rolls’ ability to stand on its own two feet,” commented the Hargreaves Lansdown analysts.

Yet even though the worst appears to be over for Rolls Royce, which saw “£4bn of cash walk out the door in 2020”, the share price could remain grounded in the near term, they added. For one, ongoing uncertainty in China continues to keep a lid on a full recovery” and, secondly, its dividend payout is still suspended.

We’re more positive than we have been on [Rolls Royce] these days. But with no dividend on offer to make the wait more palatable, shareholders should be prepared to stomach some turbulence,” they concluded.

Analysts are generally bullish on Rolls Royce, according to consensus estimates from the Wall Street Journal. The stock currently has two ‘buy’ ratings, one ‘overweight’ rating, nine ‘hold’ ratings and two ‘underweight’ and ‘sell’ ratings. 

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