As the Rolls-Royce share price hovers around 500p, I’m looking at if it has what it takes to soar even higher.
After all, it has gained 119% over the past year and a whopping 557% over the past two years. Could it possibly have any more ammo left in its tank?
In one word, yes. I believe so.
Rolls-Royce transforms
Two years ago, Rolls-Royce was struggling as the pandemic caused demand for its aircraft engines to stall. It was bloated with debt and suffered with low operating margins.
Its share price spent too much time under 100p. Then at around the start of 2023, new CEO Tufan Erginbilgic took the reins and started work to transform Rolls-Royce “into a high-performing, competitive, resilient and growing business.”
It launched a multi-year transformation programme. So far, it has made tremendous progress. Its cost efficiencies, contract improvements and other strategic initiatives have resulted in greater profits and cash flow.
This has allowed it to repay some of its debt pile, and resume dividend payments for the first time since before the pandemic.
Encouraging momentum
Today, its financials have greatly improved from a few years ago. And it has become a higher-quality share. It currently offers a return on capital employed of 15% and operating margin of 16%. This was around 6% and 7%, respectively, just two years ago.
Recent earnings updates show encouraging momentum too. In its latest earnings report, sales climbed 18% to £8.9bn, and free cash flow improved to £1.16bn from £356m. It also raised full-year profit guidance after a strong first half.
With a price-to-earnings (P/E) ratio of 25, it doesn’t strike me as an expensive share. In fact, it has traded at higher valuations in the past. And now that earnings are growing again, it looks neither too expensive nor overly cheap right now.
Potential turbulence
Bear in mind that the largest chunk of sales comes from its civil aerospace business. Despite a strong order book right now, any downturn in global travel could have a meaningful impact on its bottom line.
The pandemic might have been a rare occurrence but there’s still a possibility that air travel could be impacted again in the future.
Also, manufacturing plane engines is complex and can suffer delays or cost overruns. This can result in reputational damage.
Looking to the future
Looking ahead, there’s much to like about this business. I like that its expertise spans several key business areas. For instance, security and defence has become a global area of focus in recent years. And Rolls-Royce has been an expert in this field for many decades.
Its knowledge and expertise of nuclear power puts it in an advantageous position.
Power is likely to be a key theme going forward. Artificial intelligence has boosted the supply of power-hungry data centres. So it’s interesting to note that Rolls-Royce is one of the three leading suppliers of emergency power systems for data centres worldwide.
Overall, I think the long-term picture for Rolls-Royce looks promising. And one day, looking back and seeing its share price at 500p might feel like a bargain.
Once I add some more cash to my Stocks and Shares ISA, I’ll be buying some of these shares again.
