2023-10-18 18:17:34 ET
Summary
- Rolls-Royce experienced a significant decline in share price due to weak performance and the risk of insolvency.
- The company has managed to achieve positive cash flow and earnings through a combination of growth and cost discipline.
- The outlook for Rolls-Royce's civil aerospace and defense segments is positive, and the company is making inroads in the nuclear energy sector.
Rolls-Royce (RYCEY) is a UK-based defense and aerospace contractor. Rolls-Royce operates in four segments: Civil Aerospace, Defense, Power Systems, and New Markets.
The company builds engines for commercial jets (civil aerospace), it sells similar products and services for the military (defense), Power Systems, which develops engines and propulsion systems, and New Markets, which is involved in the production of small nuclear reactors.
Before we get into the outlook for the company, we have to address the elephant in the room.
What happened to Rolls-Royce?
The company's share price peaked in 2014, and was in a downtrend until 2019, at which point it completely collapsed.
Starting around 2014, the company began to show some signs of weakness. Though revenues continued to climb steadily, the company was forced to cut its dividend in 2015, as profitability began to take a hit.
The negative profit began to take a toll on the company, which worsened significantly in 2019 after the COVID shutdown. Rolls-Royce's revenues are much dependent on air travel.
The reason behind this huge sell-off though is not just bad performance, but an actual risk of insolvency.
As we can see, Rolls-Royce has a liability-heavy balance sheet, and a large part of these are current liabilities, which have been putting heavy financial pressure on the company.
Without a continued stream of positive cash flow, the company risks entering a vicious cycle of more borrowing and higher funding costs.
But the company has managed to turn things around for the time being, and the stock is up over 100% YTD.
Can Rolls-Royce keep this up?
A compelling Turnaround Story
In the last few quarters, RYCEY has managed to achieve positive cash flow and earnings:
This has been achieved with a combination of return to growth and cost discipline.
Revenues increased by 28% in the first six months of 2023, while gross margin expanded to 21.8%. Operating margin increased towards 9.7%, and this allowed for free cash flow of 356 million pounds and a substantial reduction in net debt.
Now, let's break it down by segment:
Civil aerospace has done very well, growing by 38% as air travel has recovered. The company made most of its revenues from the sale of large engines, which are used in widebody aircraft.
The outlook for this segment is quite positive, thanks to overall market trends, and the development of UltraFan, a new type of aircraft engine that will allegedly enable 100% Sustainable Aviation Fuel .
Our order book has grown in all three businesses. Our large engine backlog grew for the first time since 2018, including a large order from Air India in the first half. We also performed the first successful test of the UltraFan demonstrator engine. The first time all the technologies have been tested together. This program will position us well for the next generation of aircraft. Technologies from UltraFan will also improve the time on the wing of existing engines.
Source: Earnings Call
Defense has also seen a big boost here, which can be attributed to the Ukraine conflict. As I've mentioned before, exposure to revenues from military and defense certainly look like an attractive play given the increased geopolitical risk.
The UK is establishing itself as a headquarters for jet engineering. Japan, Britain and Italy have chosen Britain as the HQ for the Global Combat Air Programme, GCAP, with Saudi Arabia set to join soon.
Moving now to Power Systems, our order inflow remains robust with a book-to-bill of 1.1 times and a record level of order cover with revenues fully covered for the remainder of 2023 and 32% covered for 2024. Revenue growth was up 24% driven by stationary power gen equipment and continued strong sales of mobile power solutions in both, marine and mining.
Source: Earnings Call
It is always good to see a growing book-to-bill and stability in future revenues. This industry is projected to grow at a 7% CAGR over the next 10 years.
Ace In The Hole?
Simply based on the current turnaround, there's an argument to be made here that Rolls-Royce is still undervalued. However, what really attracts me to this stock, too, is the inroads it is making in nuclear energy.
Through its "new markets'' segment, the company is trying to achieve the holy grail of nuclear energy production. It is essentially rolling out fully functioning small nuclear reactors that can be set up anywhere.
Now, this idea of small nuclear reactors is not completely new, but there are a few concepts that might position Rolls-Royce to do very well with this product.
For one, the company has a long-established presence in the field of power. Secondly, Rolls will mostly assemble the SMR (small modular reactor) in factories. This means that it could deliver an almost finished product, which will increase convenience and could even help prospective buyers potentially bypass local regulations.
By itself, I wouldn't invest solely based on this segment, but it is certainly worth keeping an eye out for it, and it gives Rolls the potential to really surprise to the upside if it is successful, in my view.
Valuation
Even after quite a run-up in the share price, Rolls-Royce could still be at least 50% undervalued.
This valuation implies a 9% CAGR over the next 5 years, and an operating margin of around 10%, roughly in line with historical averages of growth and profitability.
Technical Analysis
Moving on to the Technical Analysis, it looks like we have a compelling impulse from the recent lows, but this implies we could be ready for a retracement:
We've had quite a good impulse, where wave 5 has now reached around the 2 ext. of wave 1 (not shown on the graph). We have since begun a retracement, which should take us back to around $1.41, the 50% level, which is also a key area of volume support.
I would be thrilled to add this to my "YOLO Portfolio" at these levels.
Takeaway
RYCEY makes for a compelling high-risk/reward investment, which is why I'd consider adding to my YOLO portfolio if we got a retracement. This is a beaten-down stock, still trading at a discount, but with a bright future outlook.
For further details see:
Rolls-Royce: Untapped Nuclear Potential And More