Rolls-Royce (LSE: RR) shares more than tripled last year, so investors have got used to good news.
However, the FTSE 100 stock got hit with a rare sell rating by one of the analyst teams covering it.
What was their beef with the shares? And is this something for me to worry about as a Rolls-Royce shareholder? Let’s take a look.
What happened
On 16 January, analysts at Berenberg bank lowered their rating on the stock to ‘sell’ from ‘hold’, citing an unfavourable risk/reward set-up.
One key issue they highlighted was recent comments made by Sir Tim Clark, the president of Dubai’s Emirates Airline. He reportedly told the jet engine maker to “go back to basics” and prioritise engine performance rather than upping its servicing charges.
This relates to earlier comments he made calling the company’s Trent XWB-97 engines “defective.”
On this, the analysts said: “Pricing, the most important factor for intrinsic valuation, will be a challenge, given current reliability issues for key engines…If history is a guide, this is the kind of issue that can derail medium-term margins for companies in the jet engine business.”
Rolls-Royce said the engines aren’t defective, but that the sandy and hot conditions of Middle East desert environments do present durability issues for all new generation engines.
Despite its bearish stance, Berenberg still increased its target price on the stock from 100p to 240p. This is 20% lower than the current price.
Elon Musk-like aura
It’s often said that valuing stocks is more of an art than a science. That is, the process can be highly subjective, making price targets more guesswork than anything else.
We can see this in the wide variation in price targets and ratings on most stocks. Some brokers say ‘buy’, some say ‘sell’ while others advise their clients to keep ‘holding’. Then there’s ‘overweight’ and ‘underweight’, adding jargon and complexity to the mix.
Beyond the quantitative aspect of valuing stocks (the number crunching), there is also the qualitative side.
For example, in its note the broker mentioned that CEO Tufan Erginbilgiç is often presented in an “Elon Musk-like aura”. That’s obviously a qualitative assessment (opinion).
What I’m doing
While I’m not too worried about this broker downgrade, there are valid issues worth bearing in mind.
One is the reputational risk, as well as additional costs, associated with the XWB-97 engine if it isn’t performing to the highest standards.
However, I’d note that Qatar Airways seemingly operates theses engines in similar conditions nearby without any major issues being reported. Hence why analysts at Citigroup think the comments from Emirates were likely part of “commercial negotiation“.
More broadly, though, the nature of the civil aerospace industry does add risk. Another external shock, like a new virus or air space closure due to war, could severely impact the company’s recovery.
Despite these risks, I’m not selling my holding. The company is targeting mid-term operating profit margins of 15%–17% in its key civil aerospace unit, up from just 2.5% in 2022.
Assuming it can achieve this ambitious target, and chip away at its net debt, then I reckon the shares will do just fine. Throw in some dividends, which are forecast to start up again, and I think the stock is still worth owning in my portfolio.
