2023-09-08 04:10:26 ET
Summary
- Rolls-Royce shares have doubled since the beginning of the year due to a surge in airline traffic in China.
- The company's Civil Aerospace segment has recovered well, with a 38% YoY increase in revenues.
- There may still be room for additional upside in the Civil Aerospace segment, but the next 20% in growth to reach 2019 operating levels may be much harder to achieve.
- With shares already fully reflecting a return to 2019 operating profits, it is time to book profits and move on.
At the beginning of the year, I launched coverage of Rolls-Royce Holdings plc (RYCEY), with the simple thesis that a re-opening of China will lead to a surge in airline traffic and a re-rating in Rolls-Royce shares. My timing was fortunate, as Rolls-Royce shares have doubled since my article (Figure 1).
As the stock has reached my long-term price target far sooner than expected, it is time to revisit my thesis to see if Rolls-Royce is still a buy at this time.
Brief Company Overview
Rolls-Royce Holdings plc ("RR") is a U.K.-based manufacturer of power and propulsion systems for commercial aircraft, defense, and other industrial applications. Its business is split into 4 main segments: 1) Civil, 2) Power Systems, 3) Defense, and 4) New Markets (Figure 2).
Rolls-Royce's Civil Aerospace segment is the largest and most cyclical of the company's businesses. The segment recorded 2022 revenues of £5.7 billion and a small operating profit (Figure 3).
The Defence segment provides engines for military aircrafts and nuclear propulsion systems for the U.K. Royal Navy. It is a steadier business reliant on long-term contracts. In 2022, the Defence segment recorded £3.7 billion in revenues and £432 million in operating profits (Figure 4).
Rolls-Royce's Power Systems segment is another steady earner, providing onsite power and energy storage systems to customers. In 2022, Power Systems earned £3.3 billion in revenues and £281 million in operating profits (Figure 5)
Finally, Rolls-Royce has a New Markets Business segment where the company groups together early-stage businesses with high growth potential like Small Modular Reactors ("SMRs") and an all-electric aircraft engine (Figure 6).
Civil Aerospace Recovered As Expected
Due to the business practice of selling aero engines at an upfront loss with profitability to be recouped through high margin Long-Term Service Agreements ("LTSA") and spare engine sales, RR's Civil Aerospace segment suffered steep losses in 2020 and 2021, as Engine Flight Hours ("EFH") were dramatically reduced due to the COVID pandemic.
EFH is a measure used by the industry for billing purposes, and readers can think of LSTAs as 'engine as a service', similar to how internet users are charged for cloud storage (Figure 7).
The main premise of my bullish initiation article was the theory that as China re-opened its economy in late-2022 / early-2023, depressed EFH was set to rebound strongly in 2023.
Indeed, that is exactly what happened. In the latest reported semi-annual earnings, Rolls-Royce's revenues and profit soared on a turnaround in global travel. For the first half of 2023, RR reported £7.0 billion (+28% YoY) in revenues and £673 million (+382% YoY) in operating profit, far ahead of analyst estimates (Figure 8).
Underpinning the company's turnaround was strong performance in the Civil Aerospace segment, which saw a 38% YoY increase in revenues to £3.3 billion and a surge in operating profits to £405 million (Figure 9).
Readers may recall this forecast from my prior article:
A return to 75% of 2019 levels could increase EFH receipts to £2.9 billion (vs. £2.3 billion in 2021) and aftermarket revenues to £3.6 billion (vs. £2.9 billion in 2021), potentially returning RR's Civil Aerospace segment to profitability.
Indeed, it appears the Civil Aerospace segment has recovered to well over 75% of 2019 levels, judging by the company's H1/23 operating results. In particular, we can see that in H1/23, Large Engine EFH was 6.2 million hours or 83% of H1/2019's 7.5 million hours (Figure 10 and 11).
The better than expected rebound in Civil EFH have led to a proportionate rise in revenues and earnings and has allowed Rolls-Royce to upgrade its guidance for 2023 full year results (Figure 12).
Compared to initial guidance from February, Rolls-Royce now expects full year operating profit of £1.2-1.4 billion vs. £0.8-1.0 billion previously expected, and free cash flows of £0.9-1.0 billion vs. £0.6-0.8 billion.
Is There Any Upside Left?
Looking forward, there may still be room for additional upside in the Civil Aerospace segment, as EFH in 2019 was 19.4 million hours, with 15.3 million hours from the Large Engine sub-segment (Figure 13).
Current Rolls-Royce operating results annualizes to only 15.4 million hours, or ~20% below 2019 levels and is consistent with the global number of flights projected to be 17% below 2019 levels (Figure 14).
However, the next 20% in growth may be much harder to come by as some consumer habits and business practices may have changed permanently due to the COVID pandemic and work-from-home ("WFH") gaining popularity.
Moreover, although year-over-year inflation in airfares have eased, they are still roughly 20% higher than in 2019, according to data from the St. Louis Fed (Figure 15). So it is understandable that demand for air travel has been diminished.
Time To Take Profits
In my prior article, I gave a long-term price target of £2.00 to £2.50 per share, assuming operating profitability can return to pre-COVID levels. The reason my target was £2.00 and not ~£10.00 from 2019 is because due to the pandemic, Rolls-Royce had to pursue a very dilutive rights offering, effectively quadrupling the share count from 1.9 billion to 8.3 billion shares. So even if profitability returns to pre-pandemic levels, there are now 300%+ more shares in circulation and thus per share profits will likewise be lower (Figure 16).
Given RR is now trading at my target price at 220p, I believe investors should consider taking profits.
Risks
There are several risks investors should consider if they are holding shares of Rolls-Royce. First, the U.K. continues to have an out-of-control inflation problem, so there is upside risk to wages, especially for large prominent manufacturers like RR. Figure 17 shows U.K. total wages are growing at an 8.2% YoY rate from April to June 2023.
Another risk for RR and other engine designers is potential design flaws that could lead to costly remediation and penalties. In 2016, a serious design flaw was discovered in RR's Trent 1000 engines and RR was forced to take a £1.4 billion charge in 2019 to remediate the issue.
Finally, although LTSA contracts have catch-up provisions to take account of inflation, it is unclear whether the increases can fully offset the hugely negative impacts of inflation on both parts and labor that RR is experiencing.
Conclusion
After a incredible 100%+ rally in the past 9 months, I believe it is time for investors in Rolls-Royce to take profits on the shares. While the recovery from 65% to 80% of 2019 Engine Flight Hours was relatively easy to predict, the next 20% will be much harder to come by, as some consumer and business practices may have permanently changed. I am downgrading Rolls-Royce to a hold .
For further details see:
Rolls-Royce: Taking Profits (Rating Downgrade)