Rolls-Royce (LSE: RR) shares fell by 10% in January. The drop meant that the jet engine maker’s share price has lagged the FTSE 100 by 9% so far in 2022.
It’s not a very encouraging start to the year, but one month is a short period in the stock market. Looking further ahead, I feel positive about the outlook for a possible investment in Rolls-Royce.
January: what went wrong?
January started under a heavy dose of caution due to the rapid spread of the Omicron variant. Additional travel restrictions were in place in some countries, with long-haul air travel especially hard hit.
Stock markets have started to sell off too. The US S&P 500 index fell by around 6% in January. I think some of that negative sentiment has started to spill over to the UK market.
One further risk is inflation. When prices rise more quickly, economic theory suggests that investors will reduce the price they’re prepared to pay for long-term assets. This is because they need higher returns to protect the value of their capital.
There’s some good news too
It’s not all bad news. January has seen reassuring trading updates from budget airlines easyJet and Wizz Air. Both companies say that any relaxation in travel restrictions triggers an immediate increase in bookings.
Covid testing requirements for entering the UK are being lifted in time for the half-term holiday on 11 February. According to easyJet, bookings have already started to rise. Of course, increased flying by these short-haul flyers won’t help Rolls-Royce much. The group’s large jet engines are mostly used on long haul routes.
However, I expect long-haul routes — especially to the USA — to be next in line for a recovery. This should provide a boost for Rolls, which generates much of its revenue from pay-as-you-fly billing for engine maintenance.
Rolls-Royce shares: I think the worst is over
I’m not suggesting that everything will now be easy for Rolls-Royce. There’s still uncertainty over how long it will take for global air traffic to recover. The company also still has a sizeable pile of pandemic debt that it needs to start repaying. Until leverage has been reduced, Rolls won’t be able to restart dividend payments.
On a short-term view, Rolls-Royce shares could still have further to fall. But I think the long-term outlook is much brighter. Chief executive Warren East has now done most of the heavy lifting required to stabilise the business, securing £1bn of cost savings.
Disposals are also on track and should raise £2bn, as hoped. Rolls has won a major new contract to provide new engines for US military B-52 aircraft and says demand is recovering elsewhere in its business.
Broker forecasts suggest that Rolls-Royce will have returned to profitability in 2021 and will see earnings double in 2022. Further gains are predicted for 2023.
Right now, the stock still looks expensive to me, on 24 times 2022 forecast earnings. But if Rolls’ recovery continues as I expect, I think the shares could look good value at 115p in a couple of years’ time.
As things are today, I’d be happy to add a few Rolls-Royce shares to my retirement portfolio.
