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I was right about the Rolls-Royce share price. Here’s what could happen next

Inside the Rolls Royce Trent 800 Engine, this engine is designed for Boeing 777 aircraft.

When I wrote about aero engine manufacturer Rolls-Royce (LSE: RR) in August, it had recently smashed through the 100p mark, losing its unenviable status as a penny stock. It appeared like just the right time to consider whether the beleaguered stock’s run-up was sustainable. 

And that is exactly what I did. My rough-cut estimates gave a conservative figure of 140p for the near future. By the end of September, the Rolls-Royce share price had breached this level as well. Further, in the same article, I said my sense was that the share price could actually be even higher in the months to come. 

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Can the Rolls-Royce share price rise more?

While the FTSE 100 stock has maintained its 140p+ level in the past three weeks, despite somewhat weak stock markets, it now seems like a good time for me to assess whether its share price can indeed rise higher. With no earnings update in the interim, the increased share price in the past month-and-a-half, has raised its price-to-earnings (P/E) ratio to a little over 15 times. This is a rise from the around 12 times seen in August. 

I have been unable to find the updated FTSE 100 P/E, but I think it is reasonable to assume it would not have changed as much, since it is a weighted average ratio of all its constituents. Also,  the index actually declined by 1% in September from August. And hit as remained unchanged from September so far this month, so the index value has really gone nowhere recently. Based on this, I moved forward with the assumption that its P/E remains at 15 times.

This may just be a good explanation for why the Rolls-Royce share price rise has stalled most recently. Based purely on how far it has risen, it is now as valuable as the average FTSE 100 stock. Unless there is reason to believe that its performance could improve far more, I think there is limited reason for its share price to rise further.  

Better financials for the FTSE 100 stock

However, there is reason to believe that it can show an improved balance sheet. There has been plenty of information available on the stock that makes it clear that it is on the right track. A crucial recent move was to hive of its Spanish subsidiary ITP Aero, which manufactures aero engines and gas turbines, for around £1.4bn to Bain Capital Private Equity and a consortium of investors. 

Last year, the company announced a disposals programme of £2bn as part of its plan to rebuild its balance sheet and help its credit profile to return to investment grade again. Since it was a large disposal, ITP Aero was a crucial step in achieving the target, which has now been met. 

This follows the disposal of its Norwegian maritime engines business, called Bergen Engines, to UK-headquartered engineering company Langley Holdings. The sale of this business to a Russian company had earlier been blocked on security concerns by the Norwegian government. It has also sold-off its stake in AirTanker Holdings, which owns the Voyager Aircraft that provides air-to-air refuelling of the Royal Air Force’s fleet.

New contract

Further, it also won a $2.6bn contract from the US Air Force to supply engines. It will now provide 608 engines, including spares and support equipment to be used on its bomber fleet. The report on this was released at around the same time as the sale of its ITP Aero business, sending its share price soaring above 140p. 

While the US Air Force contract is likely to be a long one, with deliveries made on a staggered basis over time, I think that it is great to get some revenue visibility for Rolls-Royce, which could make it easier to assess how it could perform in the coming quarters. 

Rolls-Royce’s results are wanting

In the first-half of 2021, its revenues declined by 9% compared to the first half of 2020 on a statutory basis. And there was little comfort to be found in its underlying numbers, which fell by 3.4%. Much of this was still the lockdown period. The global economy had not started recovering sustainably and the world was still struggling with Covid-19. But now that things are looking up, it is heartening to see that its performance is also picking up.

I think it may be quite crucial for Rolls-Royce to improve its revenues in the next couple of quarters to maintain its share price performance. It so happens that despite its lacklustre revenue, the company has managed to swing back into net profit, after reporting a massive loss last year. This may sound encouraging, but the fact is that it was driven by a big tax credit that accounted for over 70% of the profits. I am not sure if that will be available again. But if its revenue shows a healthy rise, perhaps the company can still stay profitable. 

Scenarios for the share price

Based on this, I see two scenarios ahead for the Rolls-Royce share price. If it sustains profits, that could be stabilising for the stock. But the amount it makes also matters. If the figure falls, then its P/E will rise, making it even more expensive and potentially less attractive to investors. If it falls back into losses, I think it could plunge back to penny stock territory again, unless it has a robust outlook. 

What I’d do

Its own performance is particularly critical right now, considering that the broader environment is hardly supportive. Stock markets are nervous about global developments, from inflation to stimulus rollbacks. Numbers released today for the UK economy were also underwhelming. The economy grew by only some 0.4% in August, underlining a slow recovery. This too, could play on market sentiment. 

On balance, I think the risks to the Rolls-Royce share price have just increased. The stock is pricier than before, that makes further increases less plausible. It does not help that the market mood is not terribly bullish either. News on its disposals and its contracts is positive, but it needs to show up in its profits. Its last earnings numbers were buoyed by tax credits. But for the shares to grow sustainably, it would be good to see higher profits come from its business. I will wait for its next set of results before deciding whether to buy Rolls-Royce stock or not. 

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Manika Premsingh 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.

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