Rolls-Royce shares drop 5%! Is this a buying opportunity?

Rolls-Royce shares tanked when the market opened on Thursday as the engineering giant highlighted that inflation was eating into profits.

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Rolls-Royce (LSE:RR) shares were down 5% one hour into trading on Thursday. The fall came as the engineering giant reported its earnings for the first half of the year.

But I think Rolls-Royce has considerable potential to grow in the long run after a difficult few years. So, let’s take a closer look at its earnings report and whether this stock is right for my portfolio.

Inflation eats into profits

On Thursday, Rolls-Royce said that underlying profit margins were lower in the first half of 2022, disappointing investors. Underlying operating profits more than halved to £125m for the first six months of the year, down from £307m a year ago.

The London-headquartered aerospace, defence and energy giant highlighted inflation and supply chain constraints as the main reasons for the fallings profits.

We expect these issues will persist into 2023 and have been managing our business to address and minimise the impact,” the group said in a statement. However, Rolls-Royce said that it expected to perform better in the second half of the year, noting the recovery in the travel sector and higher demand for long-haul flights.

Looking at the figures, earnings per share turned negative at a loss of 2.24p, from positive 1.25p in H1 of 2021.

Net debt remains problematic at £5.1bn.

Outlook

CEO Warren East said that the group should still hit its financial objectives for the year with demand for jet engines improving on the back of that recovering demand for long-haul flights.

And more generally, there are signs that the civil aviation industry is closer to pre-pandemic levels than expected. IAG, for example, says capacity for Q3 is 85% of pre-pandemic levels, while Q4 will be at 90%.

Long-term trends are positive too. As the world returns to growth, developing nations will see increasing demand for plane travel. For example, in India, the number of planes in service is expected to rise from 700 in 2021, to 1,100 in 2027 as more demand comes on board.

But civil aviation is only part of the Rolls-Royce business. In 2021, the firm generated £4.5bn from its civil aerospace division, £3.3bn from defence, and £2.8bn from power systems operations.

One area likely to receive a boost is defence, although it’s unlikely that we’ll see this impacting the balance sheet immediately. Global defence spending is on the rise and this will be enhanced further by the prolonged conflict in Ukraine.

The UK also recently announced that it was collaborating with Japan and existing partner Italy on its next-generation fighter jet programme. Rolls-Royce was already a supplier for the Tempest programme, but the partnership with Japan could open up a new geographical market to the engineering giant. US firms have typically dominated the Japanese market.

Would I buy Rolls-Royce stock?

I’d like to see debt coming down quicker, and I know the firm is looking to raise £2bn from business sales to pay off debts. It’s also true that a resurgent Covid-19 and high jet fuel prices could dampen demand for air travel. That would hurt the revenues Rolls receive from flight hours. However, I already own Rolls-Royce stock, but at the current price, I would buy more.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be considered so you should consider taking independent financial advice.

James Fox owns shares in Rolls-Royce and IAG. 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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