Rolls-Royce (LSE: RR) released its Q1 trading update this morning. It was a largely positive update with plenty of exciting developments as the firm works towards positive free cash flow. The confidence shown by CEO Warren East was also unexpected given the current economic outlook. As such, I believe that the Rolls-Royce share price has a decent chance of flying this year.
Upbeat Rolls-Royce
East started the AGM statement and Q1 trading update with plenty of positivity.
We are confident that we have positioned the business to achieve positive profit and cash this year, driven by the benefits of our cost reductions and increased engine flying hours in Civil Aerospace together with a strong performance in Defence and Power Systems, and balanced by our commitment to invest in technology and systems that are critical to the leading sustainable solutions we are delivering now and in the future.
Source: Rolls-Royce Q1 2022 Trading Update
Stocking up
It’s no secret that the UK is in for a difficult year. The Bank of England is expected to continue on its quest to tame sky-high inflation with higher interest rates. As a result, the central bank expects an economic contraction later this year, and the tears are already starting to show. March’s GDP figure indicated negative economic growth for the month.
Amid all the macroeconomic uncertainty, it’s always good to hear that a company is well prepared. Rolls-Royce is working closely with suppliers to limit disruption. It has also struck long-term sourcing agreements and designed hedging policies to limit volatility from raw materials inflation. This should give the company short-term protection as it increases its inventory levels.
Moreover, the FTSE 100 firm’s financial performance for Q1 was largely in line with guidance provided in Q4 2021. It saw low-to-mid single digit percentage growth for revenue, while the operating margin of 3.8% is expected to remain largely unchanged. And it should generate positive free cash flow by Q3 2022.
Flying high
The news for Rolls-Royce gets better. Civil aerospace, which is the firm’s largest business segment, gave a positive update. The company reported that flying hours for the first months of 2022 with service agreement customers 42% higher year on year. This should bring in more revenue as longer flying hours leads to more service maintenance. Also, I’m optimistic that the recent deal with Qantas for 24 Trent XWB-97 engines and a TotalCare service agreement will carry the segment into an operating profit this year. Updated guidance says medium-term underlying revenue will grow by an average of 10% annually. Rolls-Royce expects operating margins in the high single-digits and cash flow comfortably exceeding operating profit too.
Nonetheless, I still have reservations about the potential loss of up to 400 engine orders from the large cancellations of Airbus A330neos. Unfortunately, there was no news on this issue in the trading update. Although Airbus reiterated its intention to find buyers, it doesn’t change the fact that the A330neo isn’t a very popular model of aircraft. Perhaps queries about this may be answered at tomorrow’s Civil Aerospace Investor Day. I hope more clarity about the issue will clear the air around the Rolls-Royce share price.
| Engine Type | Airframe | Market Share | Engines in Service | Engines on Order |
|---|---|---|---|---|
| Trent 7000 | Airbus A330neo | 100% | 130 | 550 |
| Trent XWB | Airbus A350 | 100% | 764 | 859 |
| Trent 1000 | Boeing 787 | 33% | 604 | 122 |
| Trent 900 | Airbus A380 | 48% | 168 | 1 |
| Trent 800 | Boeing 777 | 40% | 176 | 0 |
| Trent 700 | Airbus A330 | 60% | 1,146 | 0 |
| Trent 500 | Airbus A340 | 100% | 92 | 0 |
| Total | 3,080 | 1,532 |
Investment for Rolls-Royce growth
Rolls-Royce is continuing to invest heavily in growth. Hopefully, this will eventually be reflected in its share price. The business expects to support new programmes while securing a larger backlog of orders as governments increase their long-term budget allocations in defence. Plus, the business has already secured a monumental contract with the United States Air Force. Rolls-Royce is contracted to replace the engines of its B-52 bombers in a deal worth up to $2.6bn.
The company’s other segments in power systems and new markets saw positives as well. The first four months of order intake was very strong across the entire business. Both power generation and defence end markets saw the biggest increases. Furthermore, the first engines for power generation, construction, and industrial applications have been approved for operation with sustainable fuels. Given the shift towards greener energy, the development of hydrogen engines should help boost the segment’s top line. More excitingly, the British manufacturer is set to sell its Spanish unit, ITP Aero. The sale should bring in about £2bn. Rolls-Royce plans to use this to pay off its staggering debt.
Speaking of debt
The biggest concern for me is that debt. In fact, the company’s financials are in a dire state. Its balance sheet shows negative shareholders equity. This means that liabilities are greater than total assets. The good news though, is that the firm has no financial obligations until 2024. Therefore, any additional cash that can be allocated this year towards improving the company’s balance sheet is more than welcome.
So, with the Rolls-Royce share price now below £1, will I buy? Well, the London-based firm has plenty of promise and tailwinds and its share price could take off. It also has an order backlog of £50.6bn as of Q4 2021. Nonetheless, I’m a firm believer in Warren Buffett’s investing philosophy. The Oracle of Omaha has repeatedly mentioned that people should only buy stocks in companies that exhibit solid fundamentals. Thus, I won’t be looking to invest in Rolls-Royce shares until its balance sheet improves. But I’ll continue to watch it.
