Rolls-Royce: Can The Stock Set New Highs?

seekingalpha09-25

Rolls-Royce has shown impressive financial performance with a 135% return since my initial buy rating, driven by strong demand and cost optimization.H1 2024 results highlight 19% revenue growth, 74% ...

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Artyom_Anikeev/iStock Editorial via Getty ImagesIn November 2023, I covered Rolls-Royce and attached a buy rating to the stock. That buy rating has performed extremely well with a 135% return compared to 25.7% for the S&P 500. Rolls-Royce is just one of several companies that I covered with a buy rating that saw stock prices double. Even since March 2024, when I revisited the company the stock has gained nearly 50% easily outperforming the global markets. I would say that the company while often plagued with reliability issues on its engines has optimized its business rather well and that has paid off for shareholders. In this report, I will be discussing the most recent results, assess the risks and opportunities, review the guidance update and update my stock price target and rating for the stock. Rolls-Royce Sees Strong Demand Coupled With Cost Optimization   Rolls-RoyceH1 2024 results were impressive. The company saw its revenues grow 19% organically, with total sales of £8.2 billion. Gross profit grew at an even faster rate of 33% as the company has been improving its cost efficiency and currently enjoys a favorable mix of high margin services revenues. Given the fact that inflationary pressures still increase the cost balance, seeing gross profit growth outpace revenue growth is impressive. Operating profit increased 74% to £1.15 billion and free cash flow improved £802 million to £1.16 billion, while net debt stood at a five-year low of £822 million. Looking at the results, the company saw strong growth on every metric.   Rolls-RoyceThe big driver of the growth is the civil aerospace segment, which saw strong growth on flight hours for engines under long-term service agreements while shop visits increased 6% and large engine deliveries to OEMs increased 4% with overall OEM deliveries being up 26%. All of this supported revenue growth of 26% driven by volume growth, but also by contract adjustments to pass on elevated costs. The civil aerospace business saw its gross profits increase as well as, Rolls-Royce has been laser focused on managing costs and has been renegotiating long-term service agreements with customers to increase margins in a mutually beneficial way. Interesting to note is that OEM and services sales were both up 27%. In contrast, General Electric saw its equipment sales fall year-on-year in the second quarter due to lower LEAP engine deliveries. By aircraft body type, we see strong upticks for business aviation as the company is ramping up deliveries of its Pearl engines to support the Gulfstream G700 and in the passenger airline segment, we saw utilization strength of single aisles result in a 33% increase in V2500 revenues. The biggest driver of revenues still are the large engines, such as the Trent XWB used on the Airbus A350 and the Trent engines used on the Airbus A330 series. Regional revenues were down, and given the operational challenges that regional airlines have been facing, that should not come as a surprise. Segment sales grew 27% to £4.1 billion, representing half of Rolls-Royce’s sales, with gross profit jumping 45% to £992 million and operating profit increasing 85% to £740 million, indicating margin expansion from 12.4% to 18%.   Rolls-RoyceDefence revenues increased 18% driven by 5% higher OEM sales and 27% higher services sales with a 34% increase in operating profits driven. The growth was supported by strong aftermarket demand, mix and pricing adjustments as well as submarine platform sales, which benefited from a one-off contract adjustment that was recognized during the quarter. Excluding this adjustment, sales would have grown by 8%, which is healthy but also shows that Defense tends to be a lower growth business as compared to Civil Aerospace.   Rolls-RoycePower Systems sales increased 6% driven by 10% higher OEM sales partially offset by 1% lower services sales with operating profits increasing 56% to £189 million. Interesting to see is that aftermarket sales for Power Systems were lower, whereas they are higher in the other reporting segments, but also for this segment we see healthy demand coupled with cost efficiency benefits. What Are The Risks And Opportunities For Rolls-Royce? Rolls-Royce has several opportunities. I believe that there is still significant growth prospect in the aftermarket business as well as the prospect of higher OEM deliveries which will provide additional growth opportunities for aftermarket sales combined with a significantly improved cost structure and higher margin contract agreements. Rolls-Royce exclusively provides the engines for the Airbus A350 and A330neo and those airplanes have seen some solid sales momentum which will drive value for the company. In Defense, we are still at the early stages of higher defense budgets translating to orders and sales, and I am particularly upbeat on the role that Rolls-Royce play in the energy transition puzzle with the small modular reactor. The main risk I see is the continued challenging environment in aerospace, with supply chains being under pressure and labor and material costs being inflated. That is something that Rolls-Royce like many other companies has to deal with, and I believe that those challenges will slowly but surely dissolve while Rolls-Royce already has significantly cut costs in its business. This should allow the company to see additional sales growth at high margins, boosting its profits.   Rolls-RoyceThe strong first half of the year underpinned by strong demand drivers that are expected to persist triggered Rolls-Royce to increase its guidance. Profit guidance has been increased to between £2.1 billion and £2.3 billion, which provides a £400 million increase at the lower end and £300 million at the higher end with free cash flow guided up by £150 million to £200 million to a range between £2.1 billion and £2.2 billion, which means that virtually all of the operating profit will translate to the free cash flow level. Rolls-Royce Has Upside On Peer Group Valuation   The Aerospace ForumTo determine multi-year price targets The Aerospace Forum has developed a stock screener which uses a combination of analyst consensus on EBITDA, cash flows and the most recent balance sheet data. Each quarter, we revisit those assumptions, and the stock price targets accordingly. In a separate blog I have detailed our analysis methodology. Valuing Rolls-Royce stock definitely is not easy, the stock trades ahead of its fundamentals when using the median EV/EBITDA for the company. However, a peer group valuation would suggest there is 28% upside for FY24 and if we let the stock trade right in between the company median and peer group valuation for FY26, there would be 10.7% upside, but doing the same for FY25 would yield a stock price target of $6.73. I mark the stock a buy as I believe the company has shown significant progress in making the business more cost-efficient and the net debt level is at the lowest level seen in the past five years. Furthermore, the company will pay a dividend over the 2024 results and plans to return 30 to 40 percent of its income to shareholders in the form of dividends going forward. All of those factors are positives and EBITDA is set to grow 10.6% annually coupled with 8% annual FCF growth, with analyst estimates for the total EBITDA generation being lifted by 20% and 15% for FCF between 2024 and 2026. So, the stock has run up quite a bit and might look expensive, but it is still trading at a discount compared to peers and I do believe that right now the stock is a buy and if the stock price drops below $6.73 that buy rating would only strengthen. Conclusion: Rolls-Royce Has A Bright Future I believe that things are looking good for Rolls-Royce, engine flight hours are continuing to increase, and we see positive demand trends for Rolls-Royce powered next-generation aircraft while defense and power generation have prospects that layer nicely on the strong civil aerospace outlook. The stock is expensive compared to its median valuation, but we also note that Rolls-Royce stock is still heavily discounted compared to peers while it has significantly improved its cost efficiency and debt levels. As a result, I do believe that the stock price could head even higher.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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