It has been a good week for aeronautical engineer Rolls-Royce (LSE: RR). The Rolls-Royce share price hit its highest level since 2021 after releasing last year’s results and announcing a restructuring.
That sent the shares up around a fifth on Thursday alone. They have doubled since October.
Can the momentum continue – and push the shares above £2 each this year?
Positive news
I think the recent strong momentum could continue. It has been driven by surging global travel demand, along with investors reassessing Rolls-Royce’s business prospects.
With almost all of the world now open for travel, albeit with restrictions, I expect demand for flights to be high for the foreseeable future. That will drive servicing revenues as engines are used more often.
As for the reassessment of what Rolls-Royce is worth in the long term, this week’s results underlined that it has the makings of a superb business. An operating margin of 6.2% might not sound huge, but as the firm generates annual revenues of over £13bn, it could translate into meaty profits. Both the power systems and aerospace divisions saw underlying annual revenue growth of over 20% last year.
If Rolls-Royce’s civil aviation division performs strongly in 2023, that could mean revenues and profits at the company overall this year rise sharply. That could boost the shares, perhaps a lot.
Possible headwinds
Despite that, I have a few concerns.
Although the firm was profitable last year on an underlying basic, its statutory loss before tax was £1.5bn. That shows the size of the firm’s ongoing challenges.
The chief executive wants to stepchange performance. Partly that involves identifying areas for growth. I think that should be good for the long-term prospects of the Rolls-Royce share price. The plan also likely involves cutting costs.
In principle I think it makes sense to align the company’s cost base with its needs and cut fat. But Rolls-Royce has already gone through an extensive restructuring process over recent years. Too much cost-cutting risks harming the company’s reputation for excellence.
In the long run, that could be problematic when it comes to sales as reputation is critical in the aviation industry. Problems at Boeing over the past couple of decades demonstrate what happens when a firm’s engineering focus is damaged by cost-cutting.
My move
I think the long-term investment case for Rolls-Royce remains attractive. The results show that the firm has been moving in the right direction by growing sales revenues. I expect that to continue this year.
Turning sales into profits is where Rolls-Royce has really struggled in recent years. The latest approach to reinvigorate the business may well work. But I also have a sense of déjà vu. It seems as if the business has already spent years trying to fix its profitability challenges, but has been unable to report high earnings consistently.
If there is good news about how the company’s latest performance improvement plan is feeding through to the bottom line, I think the Rolls-Royce share price could hit £2 before the year is out. But I also have concerns that the business could focus on saving money now in a way that hurts its long-term value. So I am holding my shares, but will be watching closely to see what happens this year.
