Over the last few months, I’ve been gradually getting more interested in jet engine specialist Rolls-Royce Holdings (LSE: RR). I’m now considering buying its shares for my portfolio.
Ready for recovery
Rolls-Royce operates a pay-as-you-go business model. The firm’s jet engines are sold at a loss and the company makes money from servicing and repairs, which are linked to flying hours. This model went badly wrong last year when airlines were forced to ground their fleets.
But in more normal times, I think this business should generate reliable, predictable revenues. Flying levels are recovering. The company said large engine flying hours rose to 43% of 2019 levels during the first half of this year, up from 34% during the second half of 2020.
Unfortunately, many of the remaining Covid-19 travel restrictions affect the long-haul routes flown by wide-body airliners. Around 50% of these use Rolls-Royce engines. This is delaying the group’s recovery, but I can’t see any reason why air travel won’t gradually return to normal over the next couple of years. As this happens, I think Rolls-Royce shares should perform well.
Boardroom refresh
In October, Rolls-Royce will get a new chairperson. Anita Frew will replace Sir Ian Davis, who’s been in the role for nine years.
Frew is currently chair of FTSE 100 chemicals group Croda International, whose share price has risen by 170% over the last five years. I regard Croda as a very good quality business, so I’d be happy for some of the same fairy dust to be sprinkled over Rolls-Royce.
More realistically, of course, turning Rolls around is likely to be a hard slog. I’m also a little concerned that Frew may be spreading herself too thinly. As far as I can tell, she plans to remain chair of Croda after she takes up the Rolls-Royce position in October. She’s also a non-executive director at mining giant BHP Group. That’s a lot of big roles, in my view.
Rolls-Royce shares: cheap?
In my experience, even the best share is only a good buy at the right price. Rolls-Royce’s has risen by 60% over the last year, but remains below pre-pandemic levels.
Broker forecasts suggest the group will return to profitability next year. Analysts’ consensus estimates price the stock on 22 times 2022 forecast earnings, falling to 15 times in 2023. I think this looks like a reasonable entry point to start buying.
Of course, there are still some risks. Chief executive Warren East needs to deliver on his target of strong cash generation. This will be needed to start reducing the group’s £4.9bn net debt.
Rolls also needs to invest in projects that will deliver a viable path to net zero. Work is underway on electric and hydrogen power solutions. But at this early stage I think there’s a risk Rolls-Royce could be left behind by smaller and more innovative competitors.
No investment’s guaranteed. But for the next few years, I’m pretty confident we’ll see Rolls-Royce’s business return to normal. In my view, this should lead to several years of rising earnings.
That’s why I’d consider buying Rolls-Royce shares today.
