UK Markets close in 2 hrs 13 mins

I was right about Rolls-Royce shares in November. Here’s what I’d do now

Young female couple boarding their plane at the airport to go on holiday.
Image source: Getty Images

The Rolls-Royce (LSE: RR) share price has risen by 20% since I spotted a potential buying opportunity at the start of November.

Should investors climb aboard the jet engine maker for the long haul? Or is this yet another false dawn?

I’ve taken a fresh look at the latest trading guidance from Rolls-Royce and the most recent City forecasts. On balance, I’m still optimistic about the outlook for this FTSE 100 engineering group. Here’s why.

3 reasons to invest

Back to normal: flying hours on the firm’s engines are rising steadily as long-haul travel returns to normal. China’s new relaxed policy on Covid-19 could also boost demand for international travel, in my view.

Improved financial health: Rolls-Royce has now started to repay some of its pandemic debt. The group’s operations are finally starting to generate positive cash flow again. Analysts expect net debt to fall from £5.1bn in June 2022, to £3.1bn by December.

Lower debt levels should give new CEO Tufan Erginbilgic more flexibility to invest in growth and restart dividend payments.

Rising profit forecasts: City analysts covering Rolls-Royce expect the group’s after-tax profit to rise from £80m in 2022 to a much healthier £500m in 2024.

Those forecasts would see the stock’s price-to-earnings (P/E) ratio fall to 15 in 2024. That’s a reasonable valuation for a market-leading business of this kind, in my view.

3 risks I can see

All stock market investments can lead to losses. This is why the returns available on successful investments also tend to be higher than those available from lower-risk strategies.

With this in mind, I can still see several potential headwinds for Rolls-Royce.

Recession: at the end of September, the company said flying hours on its large engines were up to 65% of 2019 levels. If major US and European markets suffer a recession this year, further recovery could slow.

Fuel costs: average prices for jet fuel are around 40% higher than they were a year ago, before the Russian invasion in Ukraine.

In 2022, many airlines were benefiting from hedging deals that allowed them to buy fuel below market prices. However, these deals don’t normally stretch more than one or two years ahead. That means airlines could see their fuel costs rise sharply this year.

Are the shares cheap enough? At 80p, I rated Rolls-Royce as a buy. But with the shares now trading close to 100p, this business doesn’t look so cheap to me.

The new boss needs to handle short-term economic challenges. He also needs to position the company as a market leader in low emission aviation technology.

What I’d do now

On balance, I’m encouraged by the long-term outlook for this respected business. Trading conditions and financial health are both improving.

Looking further ahead, I think there’s a strong chance the firm’s engineers will be able to develop new engines to power cleaner, greener aircraft.

For investors building a long-term portfolio, I believe Rolls-Royce is probably fairly priced at current levels. However, I don’t think the shares are obviously cheap right now. In my view, this could be a good stock to buy on the dips, gradually building a holding.

The post I was right about Rolls-Royce shares in November. Here’s what I’d do now appeared first on The Motley Fool UK.

More reading

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Motley Fool UK 2023