Rolls-Royce pins share price recovery on aviation sector

The Rolls-Royce [RR.L] share price has been on a roll: over the past month, the stock has sped away with 9.3% worth of gains, closing Friday 10 June at 87.99p. This claws back some of the losses it has experienced in 2022 — year-to-date the stock is down 28.4%.

It reported a strong set of full-year results for 2021, with the engine-maker benefitting from a more streamlined operation. Along with promising numbers comes a new strategy pinned on a recovery of the civil aviation sector.

Will Rolls-Royce maintain its upward trajectory?

Rolls-Royce’s share price losses came after its biggest investor, Causeway Capital, called for a board shake-up, questioning whether the “right people” were in place for “when sticky situations come up in September”. Another headache came in April this year when Airbus [AIR.PA] said that airline AirAsia X had cancelled orders for 63 A330neo aircraft, which use Rolls-Royce engines.

Yet, on 12 May, Rolls-Royce gave investors something to cheer about when it revealed it had turned a profit in 2021, having seen substantial losses the year before. From an investment standpoint, the company has worked hard to get itself into shape. In 2021 operating costs came in at £1.2bn, down 35% from 2019. It has also substantially reduced headcount.

By the end of 2021, operating profits stood at £414m and Rolls-Royce was sitting on an order back catalogue of £50.6bn. Free cash flow was ahead of guidance, with the company saying it expected this to improve as long-haul flying recovers.

For 2022, Rolls-Royce is expecting low-to-mid digit revenue growth and a broadly unchanged operating profit margin.

The stock trades at a price-to-earnings ratio of 60. However, with analysts expecting profits to jump to £242m in 2022, this could be reasonable.

Will the firm’s strategy be able to bring it back up to post-pandemic highs?

Rolls-Royce’s growth strategy is transitioning into an increased focus on margin expansion and sustainable cash generation, according to an investor presentation accompanying its 2021 results.

Success will depend on a recovery in the civil aviation market following the pandemic. In its investor presentation, the company said that the foundations for this recovery are in place. It also noted its dominant position in the industry, which accounts for a 58% share of large engine programmes and an 88% share of the long-range business aviation market.

While things have improved since the height of the pandemic, according to management consulting firm Bain & Company, the baseline recovery scenario for aviation demand this year is 71% of 2019 global revenue. Bain & Company doesn’t expect air travel to return to pre-pandemic levels until 2025. Headwinds for a recovery include lockdowns in China, reduced GDP forecasts and the war in Ukraine, which has resulted in a ban on Russian airspace.

Rolls-Royce also faces sluggish supply chain problems, which have hindered its ability to fully rebound.

Despite the recent gains, it’s worth pointing out that the stock has seen some volatility of late. On Friday, shares in Roll-Royce dropped 4.04% — although this is more likely down to the wider economic pessimism at the end of last week.

The 16 analysts offering 12-month price targets for Rolls-Royce have a median target of 98p, with a high estimate of 177p and a low estimate of 80p. The median estimate represents a 11.3% increase from Friday’s close of 87.99p. Of the 19 analysts offering recommendations, two rate Rolls-Royce a ‘buy’, two ‘outperform’, 11 ‘hold’ and four ‘underperform’. While no analysts have a ‘sell’ rating, it's clear that the majority have a 'wait and see approach when it comes to the stock.

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