Rolls-Royce shares soar 40%! Can the rally continue?

Rolls-Royce shares have made an explosive start to 2023. Our writer explores the outlook for the FTSE 100 aerospace stock as the year unfolds.

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Rolls-Royce (LSE:RR.) shares are the top FTSE 100 riser in 2023, so far. What a remarkable turnaround for a company that was recently described by its new chief executive as a “burning platform“.

On a 12-month basis, the Rolls-Royce share price has surged 40% on the back of strong recent results that crushed analysts’ expectations. That’s excellent news for me, as I recently invested in the business for the first time.

Naturally, such rapid growth raises questions about the sustainability of the gains. So here’s my take on the outlook for the aerospace and defence giant.

Positive results

After successive years of bad news, investors will be delighted with the company’s full-year 2022 results. Underlying operating profit of £652m represents a huge 57% increase on the year before. What’s more, the firm’s cash flow has returned to positive territory after a £2bn improvement saw it reach £505m.

In addition, net debt levels are normalising after Rolls-Royce borrowed heavily to survive the pandemic. At £3.3bn, the debt burden looks much more sustainable than the £5.2bn weighing on the company’s balance sheet at the end of 2021.

The primary source of the company’s revenue comes from its civil aerospace division. In that regard, a 35% increase in large engine flying hours is hugely positive development. This metric should continue to improve as the recovery in international travel matures.

Indeed, the rebound for Rolls’ largest business unit comes on top of continued strength for its power systems and defence arms. Now all three divisions are cash flow positive.

Passive income seekers will also note the company’s commitment to raising its credit rating to investment grade and “resuming shareholder distributions“. Although it didn’t put a timescale on this ambition, many analysts believe the Rolls-Royce dividend could return as soon as this year, if the business maintains its positive trajectory.

Turbulence ahead?

Despite the good news, the company’s still a long way away from full health. CEO Tufan Erginbilgic has highlighted “footprint efficiencies” as a target for further cuts. This suggests the possible closure of offices or factories.

Efficiency savings come with risks. Rolls-Royce already cut thousands of jobs under former CEO Warren East’s leadership. Erginbilgic is keen to assuage fears in this regard, adding: “This is not, ‘Let’s slash and burn and go’. This is about creating a company that is highly sustainable.”

While Erginbilgic’s words are encouraging, I’m acutely aware that Rolls-Royce’s reputation rests on the quality of the products it manufactures. Although I see the clear need to continue improving the balance sheet, I’m wary there’s a risk that if cuts are too severe they could impact on the brand’s association with excellence.

Should I buy more Rolls-Royce shares?

I bought Rolls-Royce shares before the full-year results at cheaper prices than today. At £1.45 per share, I won’t be adding more as the risk/reward profile has changed and I’m looking elsewhere for investment opportunities. However, I will continue to hold my existing position.

Overall, the firm has taken huge steps in the right direction and the latest results are testament to its efforts. I see every reason the rally can continue, provided efficiency savings are achieved in a sustainable manner.

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 assessed. Consider taking independent financial advice.

Charlie Carman has positions in Rolls-Royce Plc. 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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