Interactive Investor

Rolls-Royce shares rally again as faith in new boss builds

3rd August 2023 13:21

by Graeme Evans from interactive investor

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As the stock market took another tumble, the incredible recovery at the aero engine maker took another step forward. Our City writer explains what’s going on.

Rolls-Royce jet engine 600

The dramatic Rolls-Royce Holdings (LSE:RR.) turnaround story resumed today as half-year figures convinced more investors that the engine giant’s upturn in fortunes is built to last.

Details within interim results helped the FTSE 100 stock to revisit the peak seen during last week’s buying frenzy, when Rolls’ forecast full-year operating profit as much as 55% higher than the City consensus at up to £1.4 billion.

The shares, which are back among the most popular on the ii platform, recovered from a lacklustre start this morning to stand 5% higher just above 193p at one point in the session.

Analysts at UBS said following the results that they are increasingly comfortable that the improvements under new boss Tufan Erginbilgic  are “broad-based and sustainable”.

They pointed to the civil aerospace operating margin, which has jumped to 12.4% from minus 3.4% the year before as Rolls achieves higher aftermarket profitability and benefits from a jump in large spare engine sales.

UBS also highlighted a 6.5% reduction in commercial and administration costs, even though Rolls experienced a 39% increase in sales.

The bank has a price target of 200p, but this does not take into account any adjustments still to be made after today’s half-year results.

The figures showed an overall operating margin of 9.7%, much better than the 2.4% the year before but clouded by a fall in power systems to 7%. Pricing actions means Rolls expects the margin in this division to improve in the second half.

Overall underlying operating profits rose to £673 million, up from £125 million, on revenues of £6.95 billion as the multi-year transformation under Erginbilgic starts to take shape.

He added: “There is much more to do to deliver better performance and to transform Rolls-Royce into a high-performing, competitive, resilient, and growing business.”

He plans to reveal the outcome of a strategy review along with medium-term goals for the business in November.

Bank of America is optimistic that Rolls can close the “excessive” valuation gap to peers MTU and Safran, particularly given the room for margin expansion in the power systems division.

The bank has a price target of 260p, which it increased from 190p in the wake of last week’s strong update.

It sees the potential for dividend payments in the 2024 financial year as the balance sheet has become less of a concern for investors, highlighted by today’s big improvement in cash flow to £356 million from an outflow of £68 million in the prior period.

For now, however, Rolls will need to focus on returning to an investment grade credit rating before it can consider shareholder distributions.

Better cost management and this year’s anticipated improvement in engine flying hours to 80%-90% of 2019 levels means the company’s new cash flow guidance for 2023 is now in the range of £900 million to £1 billion, up from £600 million to £800 million in February. Bank of America believes favourable tailwinds can drive this to £1.9 billion in 2026.

When former Rolls boss Warren East reported results last August, the company recorded £68 million of outflows compared with the positive £356 million seen today.

Shares were 80p after East delivered those results, still 10p lower than the sum paid by banks for surplus shares in November 2020’s heavily discounted £2 billion rights issue. That fundraising offered existing investors the chance to buy shares at 32p a share.

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