After Earnings, is Rolls Royce Stock a Buy, a Sell, or a Hold?

Rolls-Royce just announced stellar profits and its share price over one year to February 2024 is up over 160%. But how does Morningstar value its stock?

Christopher Johnson 28 February, 2024 | 11:13AM
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Narrow-Moat Rolls-Royce's (RR) full-year results for 2023 were stronger than anticipated, as the business recorded high group profit margins driven by its civil aerospace performance. These strong results come after a 160% gain in Rolls-Royce's stock price over one year. 

Rolls-Royce said its underlying operating profit jumped by £938 million to £1.6 billion while its 2023 revenues increased to over £15 billion. It now predicts underlying profits for 2024 will hit a whopping £2 billion, and that the business will generate around £1.9 billion of free cash flow. 

The company was also boosted by an increase in its civil aerospace operating margin, which reached 11.6% in 2023 versus 2.5% in 2022, on the back of higher percentage of spare-part sales, increased time on wing benefiting long-term service-agreement contracts, price optimisation, and cost efficiencies. 

Subsequently, Morningstar increased its fair value estimate for Rolls-Royce's shares from 289p to 380p because of an increased confidence in the firm's civil performance delivery.  

Key Morningstar Metrics for Rolls Royce Stock 

•F air Value Estimate: 380p

• Morningstar Rating: ★★★

• Morningstar Economic Moat Rating: Narrow

• Morningstar Uncertainty Rating: High

Rolls Royce Stock Price Gain - Explained

For Loredana Muharremi, equity analyst at Morningstar, Rolls Royce's 160% share price growth can be attributed to a corporate restructure.

Since 2016 the company's return on invested capital has been below the weighted cost of capital. The business also faced challenges before the pandemic due to issues with its Trent 1000 engine and because of poor capital allocation decisions.  

For Muharremi, one of Rolls-Royce's most significant strategic errors was exiting its exposure to the narrow-body aircraft market in 2012, when it sold its 37.5% stake in International Aero Engines, a joint venture to produce the V2500 engine.  

"Between 2008 and 2017, Rolls-Royce focused on investing heavily in building market share by developing seven new engines and ramping up industrial capacity with investments in R&D reaching 10% of revenue, versus 6% of peers exposed to growing narrow-body market, without a clear path from management on how to recover the investments given the shrinking market share of wide-body aircraft," she says.  

However, with the appointment of Warren East as chief executive in 2015 (he stepped down at the end of 2022), change was afoot. That included disposing of non-core assets. 

"The Covid-19 pandemic and its impact on wide-body aircraft demand further deepened Rolls-Royce's restructuring program, resulting in £1.3 billion in structural annual cost savings through measures such as job cuts and production site consolidation," she says.

"This restructuring effort included shedding 9,000 jobs, which represents about 30% of the civil aerospace segment's workforce."  

Muharremi also notes that Rolls Royce reduced its targeted R&D spend to 5% of sales, to shift the focus away from the current fleet to next generation engines and low-carbon alternatives.  

"We believe the restructuring as well as the new R&D target spending and mix were necessary to align the group with the lower demand outlook over the medium term for its suite of wide-body engines," she says.

"Moreover, the company used the Covid-19 time to focus on increasing engines performance in terms of durability (extending time on wing ) and reliability, solving most of the thrust issues that the engines presented." 

Why Has Rolls Royce's Fair Value Estimate Increased?

Muharremi argues the Fair Value Estimate for Rolls Royce has bumped up because its commercial performance exceeded expectations.  

"The company delivered already 40% of the expected mid-term performance improvements (time on wing extension and increased reliability) ahead of schedule," she explains.

"On the back of its improved engine performance the company exceeded our expectation in terms of commercial performance as it was able to negotiate higher pricing than expected on new contracts and existing RPFH contracts that were up for renewal. 

"Recovery in demand for both OEM and aftermarket from Covid-19 levels, with the high margin aftermarket business recovering ahead of ASKs due to pent-up demand, lower cost structure (explained above), and increased engine performance."

Rolls Royce has 90% of its fleet signed with long-term revenue per-flying hours (RPFH) contracts, so engine performance improvements drove higher RPFH profitability.

This also allowed the business to negotiate for higher prices. In light of this, Muharremi expects price increases to continue as the company continues delivering on engine performance and the mix shifts towards more profitable new RPFH contracts. 

Rolls-Royce's Economic Moat Rating 

Muharremi assigns the business a Narrow Economic Moat because of its intangible assets, its technical know-how and engineering expertise across the civil aerospace and defence segments of the company.  

The civil aerospace division generated 48% of total revenue in 2023, with 70% from large engines, and 28% from business aviation and regional sectors. As a sector it has high entry barriers, ranging from stringent regulatory requirements to rigorous safety, reliability, and durability qualification processes.  

Only four companies, including Rolls-Royce, have the technological expertise and capacity to design, manufacture, and service large commercial aircraft engines. 

"The production of engines requires significant capital upfront, extensive research and development investments, and skilled workforce," she says.

"Rolls-Royce employs a large team of skilled engineers and invested up to around 10% of its revenue in research and development from 2010-17, resulting in 1,994 patents. The civil aerospace industry should realise a recovery as RPK, or revenue passenger kilometres, increases following the covid pandemic".

Muharremi has also assigned Rolls Royce a narrow moat because of its defence business. Its program wins in the defence sector are typically long term, creating high barriers to entry and fostering intense competition among established players for new opportunities. Within the defence business, services contribute to 54% of total revenue.  

"Unlike the commercial aerospace sector, the defence sector faces challenges in centralising maintenance due to the greater geographical dispersion of customer assets," she says.

"Consequently, attachment rates of long-term service contracts are low, at around 30%."

As a result, Muharremi believes that most of the service-related revenue comes from the sale of spare parts to a fragmented base of third-party service contractors.  

"While the fleet of 16,000 in-service engines globally generates high-margin revenue, the MRO defence segment does not benefit from significant switching costs due to the low attachment rates," Muharremi adds. 

Rolls-Royce Risk and Uncertainty 

However, Morningstar has given Rolls-Royce a High Uncertainty Rating because of the inherent cyclicality of the aerospace industry, links to the global economy, and uncertainty based on concentration risk on wide bodies' outlook. 

According to Muharremi, Rolls-Royce's business is exposed to high cyclicality as approximately 45% of the company's adjusted consolidated revenue and 34% of EBITDA comes from civil aerospace activities.  

"As well as airlines' profitability being closely tied to factors like global economic growth, and oil prices. A downturn in these factors might lead to airlines tightening their budgets, reducing orders, or postponing maintenance, all of which could harm it," she says. 

Yet she remains confident that Rolls-Royce will recover in the medium term because the impact of each economic downturn cycle on aircraft deliveries has been shorter and less intense than previous ones. RPK has also consistently exceeded gross domestic product growth.  

"The risk of wide-body aircraft weaker than forecast demand due to order cancellations, early retirements and reduced flight hours will negatively affect the in-service fleet size and aftermarket margins," she says.

"Cost inflation and supply chain challenges, exacerbated by the war in Ukraine, could potentially affect delivery rates and margins in the short term."

However, Muharremi believes that Rolls-Royce, with its large and young in-service fleet and proven ability to deliver operational efficiencies, should be able to remain profitable, though it may face a difficult short-term period ahead. 

RR Bulls Say 

• Losses from new engine deliveries will decrease as Trent production ramps up;
• High-margin service revenue can be expected to jump as in-service fleet grows;
• A leaner and more focused business will emerge from the corporate restructure.

RR Bears Say 

• Rolls-Royce faces a highly uncertain recovery from Covid-19;
• Structural demand shifts favouring narrow-body aircraft could have a negative impact;
• Customers are growing concerned over the firm's ability to honour long-term contracts.

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Christopher Johnson  is data journalist at Morningstar

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