Can Rolls-Royce fly high again?

It’s the final results day for Rolls-Royce tomorrow and I want to quickly assess whether they’re investable on what we know currently and will look again after the announcement to see if this short assessment was even close. Now I know looking at last year’s figures is a bit of a waste of time but it’s a start so here goes.

Now to start you haven’t been getting any dividend payments from RR since the outbreak of COVID-19, this is down to the civil aviation area of the business really struggling due to lock-downs and countries closing their borders and with RR Civil Aerospace contracts being based on the number of flying hours. Now civil aviation has traditionally been a very big part of their business model so in order to save this they stopped dividends, completed a rights issue, took on debt and sold off some pretty big parts of the business. So, straight away, we know based on the aforementioned, Rolls-Royce is smaller (due to selling off parts of the business), it’s got more debt and has a lot more shares in circulation.

The rights issue in 2020 offered 10 new shares to current shareholders for every 3 shares they had, which means if you already had shares you could purchase more at a price of 32p each which at the time was around a 40% discount and raised about £2bn. You can no longer compare the share price before the rights issue without taking this into account. On top of this RR sold off assets including Bergen Engines & ITP and raised another £2bn. The total debt pile at RR was around £7.8bn at last year’s review so this should be less than £6bn now.

Were they investible?

So taking last year’s financials (with a pinch of salt) and the current share price, how do they stack up?

Pretty surprising actually, things appear to be getting worse but comparing FY and HY is never ideal. Certainly based on the above they are not good value, they are not paying any dividend and based on book value they are worth… well avoiding really.

However, we know that the above appalling stats are the result of the pandemic which knocked Rolls-Royce and several others very badly. However looking into the past, it also appears that RR was struggling prior to the pandemic as cash levels at the company have been heading south since 2018, net income has almost exclusively been negative since 2018 and debt was rising even prior to this, so surely if that’s the case unless something drastic changes you’d be forgiven for writing them off. Before the pandemic, RR was dealing with a fault with its flagship engine the Trent 1000 which involved cracking of the blades and meaning RR was having to support these engines globally with resources completing inspection activities and effectively swapping items out at short notice, at its peak RR had 44 aircraft on ground as a result of this and spent approx £800m in one year alone trying to keep aircraft flying safely while also finding a permanent fix. Thankfully this task was completed in 2020. So is the worst behind them?

Looking into the future…

A lot’s changed, not only has RR fixed its main issue the Trent 1000 blades but it’s managed to find a path through the pandemic. Now we have a war in Europe and a global drive towards green technologies and China finally opening up to the world and allowing its citizens to travel. The latter seems positive but with China increasingly aligning itself with Russia does this cause concern? We shouldn’t allow that to come into play if we have no idea what the outcome will be though I guess.

Now Rolls-Royce as a company has some really important things going on, they are currently pushing their small modular reactors (SMR) of which they have a 70% stake as an alternative (obviously) to fossil fuels but also to larger (EDF) nuclear sites, now through into the mix that the EDF offerings are largely (approx 33%) bankrolled by Chinese firm CGN and you have some real potential here. Not just that the Chinese bit is a political hot potato but also that EDF has effectively been purchased by the French state to keep them in business. RR has a very good alternative that can be implemented relatively quickly and comparatively cheaply. One issue though is funding and RR has been pushing the British government to assist with this for some time but so far only limited assistance is forthcoming. Something else to note is that nuclear power projects have recently been granted “green” status” this (in theory) means that billions of pounds of funding could be unlocked for the industry. This is very timely and may not be a coincidence. Also, a side note – Rolls-Royce (SMR) has just signed a memorandum of intent (MOI) with the Polish industrial group, Industria allowing the two companies to collaborate on possible deployment in Poland, perhaps this will hurry things up in the UK?

On top of this, RR Power Systems (MTU) which provides the engines for Leopard and Puma tanks in Germany could potentially see a large upswing in demand although nothing as of yet, but with Germany announcing a plan to prioritise Defence spending and pledging €100b for 2022 alone and given that they have now agreed to supply Ukraine with Defence equipment along with pretty much all of Europe. Leopard tanks (which are being handed over to assist Ukraine), it seems likely demand could increase in the near future.

Also, let’s not forget Rolls-Royce covers nuclear for the armed forces, and HMS Anson one of the Astute Class nuclear-powered attack submarines has just commenced her maiden voyage. Soon she’ll be undertaking sea trials with the four other Astute Class submarines already in operational service. HMS Anson is the fifth with seven planned. RR already provide gas-turbine engines for the Navy, including the Type 45 destroyers and the Queen Elizabeth-class aircraft carriers.

RR is even involved in developing a prototype nuclear reactor for Spaceflight! Did I mention eVTOL aircraft? I know, I know, I won’t dwell on this as it’s likely a while away and won’t be particularly profitable in the short term. But it shows they have a lot of markets to tap into and some of these markets are going to be very difficult for others to enter.

… and the now? Are Rolls-Royce shares a buy?

Flying hours are not far off of pre-pandemic levels and short of something major happening I see no reason why this won’t continue to improve, in addition to this an announcement on the 14th of February confirmed RR signed its biggest-ever order for its Trent XWB-97 engine as Air India signed an MOU to purchase 68 with the option for another 20, they also announced 12 Trent XWB-84 engines, this is big especially when you consider Air Indias growth plans. So on paper RR Civil Aerospace is back and RR is fighting fit.

On top of this, the demand for Defence hardware is certainly not going to be decreasing and RR is delivering on current contracts and is likely to receive more, potentially a lot more. Also, Britain recently agreed to transfer Jet engine technology to India, primarily for Defence it seems and Roll-Royce will clearly be a big player in this.

Full disclaimer, I already have a holding in RR. In fact, it’s my largest single holding so I want them to do well. With the FY announcement tomorrow should I sell, buy or simply be satisfied with what I already have? Having read up on Tufan Erginbilgic’s (RR CEO, started last month) speech from a few weeks back addressing his employees globally I think he has the share price in mind and wants to make a difference as quickly as possible. Taking all of the above into account I don’t think it can go too badly for him as the groundwork is already complete. It seems likely that he will be looking to cut costs wherever he can and let’s be honest costs have been an issue at RR for a very long-time, in addition to this the debt burden is large and they really need to be more competitive especially if the investors ever want to see a dividend again. I’m reading in certain press releases that it’s likely Tufan will be making an announcement regarding a turnaround plan alongside the annual results. This seems likely to me as he clearly wanted to set a narrative when he made his speech to the company a few weeks back.

Given all of this, I think that the company is a buy but I won’t be increasing my holding and feel it’s probably best for me to top up others (or add new ones) therefore reducing the percentage share in my portfolio designated to Roll-Royce. Anyway, the whole point of this was for me to assess prior to tomorrow’s announcement and then reassess post it, so with that in mind please wait for the next exciting Rolls-Royce instalment within the next week or so!