Despite posting a reasonable set of results last week, the Rolls-Royce (LSE: RR) share price remains under pressure. It is now down 16% in a week and is back in penny stock territory. Looking at a slightly longer time frame, if I removes the falls suffered over the last week, its share price has remained flat over the past year.
Although I have long been an admirer of this British engineering icon, I am yet to be convinced that it makes a worthy addition to my portfolio. The question for me is what, if anything, would make me change my mind?
A long road to recovery
Compared to the horror show that was 2020, headline figures for 2021 were encouraging. Gross profit was £2bn and operating profit came in at £414m. Although free cash flow improved significantly, it still represented outflows from the business of £1.5bn.
In its largest division, civil aerospace, engine flying hours (EFH) rose 11% on 2020, but were still significantly below 2019. The company did, however, see a 57% rise year on year in EFH in the second half of 2021 as travel corridors reopened.
Despite these encouraging figures, it is becoming increasingly apparent to me that in order to secure its long-term future Rolls-Royce needs to diversify its business model. Relying on assumptions about when air travel will return to pre-Covid levels is not only dangerous, but a pointless exercise. The heightened geopolitical risks and inflationary pressures at the moment demonstrate that.
A new, leaner Rolls-Royce
The restructuring of the business with a far smaller footprint and leaner workforce has undoubtedly stopped the haemorrhaging of cash. I am also encouraged by the fact that defence and power systems now account for 60% of total revenues. Indeed, in 2021 power systems had a record order book. This is clear evidence that the business is beginning to pivot away from relying solely on EFH.
However, the really exciting parts of the business is its ‘new markets’ division. Composed of small modular reactors (SMR) and electrical, it estimates that these combined businesses could generate £5bn in revenue by 2030.
However, a great deal of uncertainty exists as to when these businesses will begin generating revenue for the group. Most of these technologies are still very much in their infancy. In this respect, it is acting more like a start-up than an established business as it attempts to paint a picture of the world of tomorrow for would-be investors.
In the more medium term, its most promising business is power systems. As the world transitions to a low-carbon economy, the shorter development cycles and established customer base provide a more concrete revenue estimate.
One of the key challenges the business faces is balancing investment in new markets while looking after existing business. After all, it needs revenues from its core business to fund all these new projects. However, it has one key competitive advantage and that is a decades-long record of innovation.
Despite the growing portfolio of opportunities, the investing world still pretty much sees Rolls-Royce as a manufacturer of aircraft engines that also maintains them. As long as that remains the case, its fortunes will continue to be tied to air travel demand. Therefore, I will not be investing yet, but it remains on my watchlist.
