Rolls-Royce (LSE: RR.) shares took a knock last week, sliding almost 6% in a broader sector sell-off that began on Monday, 18 August.
The drop followed news that peace talks between Russia and Ukraine were gaining traction. US President Trump met with Presidents Putin and Zelensky last week, sparking speculation that defence budgets could shrink if the conflict winds down.
The irony is that just a week earlier, US officials had downplayed the likelihood of a ceasefire deal – a move that had actually lifted defence stocks, including Rolls.
Reports suggest Trump offered Zelensky security guarantees as part of a potential settlement. Unsurprisingly, investors were quick to react. On the Monday after the talks, Babcock shares dived 7%, though they’ve since bounced back. BAE Systems and QinetiQ also suffered, but both have largely recovered.
Rolls-Royce, however, is still drifting lower.
Could there be more at play?
Analysts suggest the pullback may not be entirely about geopolitics. Speaking to Reuters, Marcus Gavelli of Pareto Securities said he sees “some profit-taking after a strong run”, calling the dip more of a short-term reaction than a change in fundamentals.
That makes sense. After all, Rolls-Royce shares have been on a spectacular rally over the past 18 months, up several hundred per cent from their pandemic lows. With a forward price-to-earnings (P/E) ratio of 37, it’s not cheap. But then again, that’s not unusual for a growth stock.
Profitability remains exceptional. The company boasts a net margin of 30% and a jaw-dropping 148% return on capital employed (ROCE). Even with £5bn of debt on the books against £2.5bn in equity, strong cash flows mean the balance sheet still looks manageable.
Perhaps what investors are really asking is whether the ‘Rolls rally’ has finally run its course.
Not slowing down
If anything, the business looks to be gathering pace. On Thursday, 21 August, Rolls announced a significant order for 50 MTU Series 4000 engines from Switzerland-based Stadler Bussnang. These will power high-speed trains in Saudi Arabia, with 10 trains set to run at up to 200 km/hour between Dammam and Riyadh.
The company also finalised the sale of its UK pension fund to Pension Insurance Corporation in a £4.3bn deal, strengthening its financial position. And just last month, it upgraded its full-year underlying operating profit guidance – hardly the behaviour of a business slowing down.
That said, risks remain. The share price is highly sensitive to sentiment, and any wobble in defence spending could add pressure in the short term. Debt is also a consideration, even if cash flow currently makes it manageable.
But I think the biggest risk here isn’t the balance sheet or defence cuts, but investors losing faith after such a rapid climb.
My verdict
Personally, I don’t expect changes in defence budgets to have a meaningful long-term effect on Rolls. The company’s commercial jet engine and power generation divisions continue to grow, and recent contract wins highlight the diversity of its operations.
Yes, the shares look expensive after such a rapid climb. But with profitability soaring and new orders still coming in, I think Rolls-Royce shares remain worth considering – even at today’s elevated price.
