Rolls-Royce (LSE:RR) shares have jumped in recent months. In fact, the FTSE 100 stock is up 30% over six months — but still down 6% over a year. Normally, I’m cautious about buying shares on a bull run, but not this time.
Despite some worrying comments from its new CEO, Tufan Erginbilgic, I believe the engineering giant will continue to make gains as the operating environment improves throughout 2023.
So, let’s explore why.
China is back
You’re unlikely to find Rolls-Royce engines on small intra-city/European flights. But in China, wide-body planes with two aisles and Rolls-Royce engines are often used for short-haul routes.
Since Beijing announced a reduction of Covid restrictions in December, civil aviation has surged in China. Figures released this week highlighted a 34.8% year-on-year leap in January. This was a month in which Covid-19 rates were at an all-time high, albeit during the Spring Festival holidays.
Passenger numbers have recovered to 74.5% of the same period in 2019, according to the Civil Aviation Administration of China.
This data was preceded by airline reports on Wednesday. Air China said its passenger turnover rose by 62.2% year on year in January, or 121.6% month on month.
Meanwhile, China Southern Airlines said that its passenger turnover in January calculated by revenue passenger kilometres increased by 44.62% on the year.
International flights are recovering more slowly, but growth is expected to continue. Shenzhen airport will have nearly 120 international passenger flights per week by the end of February, double the number at the end of January.
Why is this important?
The civil aerospace business, which still generates 40% of underlying revenue, reported that Large Engine Flying Hours were around 65% of 2019 levels towards the end of last year. This is particularly important as the firm earns money from engine performance hours, and not just the sale of engines.
China’s reopening should see this figure increase greatly, although it’s unlikely to have any material impact on 2022 results, which are due on February 23.
However, we should see increasing evidence of a recovery in civil aviation in other parts of the world. The ICAO now forecasts that air passenger demand will rapidly recover to pre-pandemic levels on most routes by the first quarter of 2023. It also predicts the industry will be 3% bigger than 2019 by year end.
This is game-changing for Rolls-Royce, a firm whose market cap is 51% smaller than it was three years ago and nearly 70% down from a 2019 peak.
Unfortunately this doesn’t mean Rolls will rebound to 2019 levels any time soon. The group took on considerable debt during the pandemic and only reduced this indebtedness by selling £2bn worth of business units.
Clearly, Rolls needs to work on its £4bn of debt, because this will act as a drag on profitability going forwards. However, I’m buoyed by the Chinese reopening, as well consistently strong performance in its power systems and defence business segments.
As such, I’m looking to buy more Rolls stock before the end of the month. I’m backing it to outperform the index in 2023.
