It’s been a good year for Rolls-Royce (LSE:RR) shares. While the engineering giant is still trading firmly below pre-pandemic levels, the stock has delivered a spectacular return of nearly 90% over the last 12 months!
Is this the start of the long-awaited turnaround? And should I be considering this business for my portfolio?
Flying hours are on the rise
Aerospace companies have been struggling following the decimation of air travel in 2020. The situation for Boeing has been particularly challenging since its 737 Max model was grounded after two tragic crashes before the pandemic even kicked off.
Today, the situation isn’t as bad, but there remains a lot of work ahead. Production delays for new aircraft caused by supply chain disruptions continue to plague the industry. And order books for most major players now stretch well into the 2030s.
However, while the delivery of new aircraft is slow, the number of long-haul flying hours is back on the rise. And the latter is terrific news for Rolls-Royce shares. Why? Because the longer planes are in the air, the sooner they’ll need the firm’s maintenance services.
In a May trading update, management said customer flying hours of its large-engine fleet stood at 83% of 2019 levels. And based on current trends, this could reach as high as 90% by the end of 2023.
What’s more, with the group’s other divisions, such as Power Systems and Defence, securing new contracts, management has re-iterated guidance of £0.8bn-£1bn in operating profit for 2023.
Needless to say, this is excellent news for the business. And it’s certainly a good start to Tufan Erginbilgic’s tenure as CEO since taking the corner office in January.
What lies in store?
Looking at analyst consensus, there is an overwhelming expectation that the firm’s bottom line will finally be back in the black by the end of this year. And not by a small amount.
Consequently, some analysts are predicting the share price could climb as high as 255p in the next 12 months. Compared to today’s valuation, that would suggest plenty of upward potential in store.
However, not everyone is in agreement. In fact, there are others expecting Rolls-Royce shares to tumble to just 92p. And this more pessimistic view isn’t without its merits.
There’s no denying that operations at Rolls-Royce have drastically improved in recent months. But plenty of work remains to fix the company’s balance sheet.
The continuous string of losses before Tufan’s tenure led to a significant build-up in debt. And this problem only got amplified by the pandemic.
As such, the group currently has nearly £6bn of outstanding loan obligations and lease liabilities. This is a significant improvement versus £7.8bn in 2021. But with interest rates on the rise, pressure on the bottom line is slowly rising.
Management has already highlighted its intentions to drastically reduce its debt pile using the newly generated free cash flow. However, that also means there are fewer funds for new innovations, potentially creating opportunities for competitors.
All things considered, I’m still sitting on the sidelines for this one. The group’s change in strategy is clearly having a positive impact. But Rolls-Royce shares still have a lot to prove before I’m tempted to add this business to my portfolio.
