Why Rolls-Royce shares could continue to outperform the index!

Dr James Fox takes a detailed look at Rolls-Royce shares and explains why he think investors engineering giant will bounce back.

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Rolls-Royce (LSE:RR) shares pushed upwards again last week as the company surprised to the upside. The earnings report showed us that the FTSE 100 firm’s recovery is much further along that many analysts anticipated.

The stock is up a phenomenal 106% over six months — it hit its nadir under Liz Truss’s disastrous premiership. A fair proportion of those gains came after February’s results.

So why do I think Rolls-Royce could continue to push upwards and outperform the market? Let’s take a closer look.

A smaller company

As we know, Rolls-Royce suffered during the pandemic. That’s because it’s highly reliant on something called Large Engine Flying Hours, which makes up around 40% of revenue.

The company essentially makes money on engine performance hours, not just the sale of the units themselves. So when civil aviation ground to a halt during the pandemic, Rolls suffered and had to take on £2bn in government-backed debt.

And in order to pay off that debt, it sold business units and it undertook a rationalisation drive which saw jobs cut. So Rolls is a smaller company today than it was before the pandemic.

Performing at pre-pandemic levels?

In 2022, revenue grew to £13.5bn. That was a considerable rise from 2021, but below 2019 when the company generated £15.4bn.

But I’m wondering if a leaner Rolls-Royce could be set to surpass pre-pandemic revenue generation sooner than we were expecting. After all, there’s a real buzz around the business right now and the forecasts are positive.

Firstly, looking at civil aviation, the engineering giant said that Large Engine Flying Hours were around 65% of 2019 levels towards the end of 2022. But for 2023, the firm is expecting this metric to hit 80-90% of 2019 levels.

This suggest a further 15-25% growth. A fair proportion of this could be generated by China’s reopening, where wide-body jets, with Rolls engines, are used on domestic flights.

Looking further into the future, it seems logical that Air India‘s mammoth order for new planes — along with other airlines — represents a sizeable long-term source of revenue generation for the firm.

Meanwhile, the company’s other two main business segments, power systems and defence, are performing very strongly too. Orders for power systems were up 29% to £4.3bn in 2022. Defence is progressing solidly amid an increasingly tense geopolitical environment.

With the above in mind, could a leaner Rolls-Rolls surpass its pre-pandemic self in the near future? I think so. But there is one issue. Debt. At £3.3bn, the burden looks much more sustainable than it was just a year ago, but repayments will drag on profitability.

Up 108% over six months, down 48% over five years, Rolls is quite unique. But, for me, the future looks bright and I’m buying 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 assessed. Consider taking independent financial advice.

James Fox 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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