Image source: Rolls-Royce plc
It has been a remarkable few years for aeronautical engineer Rolls-Royce (LSE: RR). Trading in pennies as recently as 2022, Rolls-Royce shares have soared 616% over the past five years. Wow!
Could there be reasons to stay optimistic about the business outlook for Rolls? I reckon so.
Here are three.
1. Ongoing high demand in civil aviation
Trade policy disputes have raised the spectre of greater complexity when selling plane engines, as well as potentially lower travel demand.
But while I see those as risks, they can obscure the fact that civil aviation has been on a roll in the past several years.
Demand from airlines for new engines remains robust. Rolls’ underlying revenue in civil aviation last year grew 24% organically.
A large installed base and high usage means that there will likely be strong demand for servicing too. With Rolls’ large installed base of engines, that is good news for the business. As it said in a trading update this week, the business is seeing “strong aftermarket revenue growth driven by higher shop visit volumes”.
The firm also said that it expects “to offset the impact of announced tariffs on our business through the mitigating actions we are taking”.
2. Robust demand growth in defence
While civil aviation is the core of Rolls-Royce’s business – and so its share price can be heavily affected by it – defence is also a sizeable division. Last year, it delivered £4.5bn in revenue for the company. That was about a quarter of the firm’s total.
A deteriorating security environment in Europe, coupled with US geopolitical uncertainty, is likely to see defence spending grow at a strong clip in years to come. That ought to be good news for UK defence shares including Rolls.
Last year, its underlying defence revenues recorded organic growth of 13%. As the company reiterated this week, “In Defence, demand remains robust across our portfolio of products with strong order intake”.
3. Ongoing drive to improve profitability
Those two factors are external. But I see an internal growth driver too that could help push Rolls-Royce shares even higher: improved productivity feeding through to higher profit margins and earnings.
Rolls-Royce shares soared in recent years partly due to an aggressive set of goals for key financial metrics.
To investors’ delight, the company has since raised those goals, covering the period until 2028. This week, it said, “good progress on our transformation and the actions we are taking” gave it confidence to affirm its financial performance goals for this year.
Lots to like, so should I buy now?
I see these potential growth drivers as real and substantial, so should I buy?
I do not plan to do so.
The current Rolls-Royce share price-to-earnings ratio is 26. That valuation is too high for me.
Why? In short, the company (and its competitors) are subject to large potential external shocks that are outside its control.
Tariffs are merely the latest example. A pandemic, large-scale weather event, terrorist attack, or recession hurting civil aviation demands are among the others. We have seen it before and sooner or later I expect we will see it again.
