Investors are cashing out of Rolls-Royce (LSE:RR.) shares after its stunning multi-year run. Down 5% over the last week, the engineer is falling as the Middle East conflict drives market tension higher.
And I’ve spotted five potential reasons why it could continue falling further…
1. Weaker services demand
One reason is a sharp decline in the civil aerospace sector. This is the company’s single largest end market, accounting for more than six-tenths of underlying operating profit.
The lion’s share of this comes from servicing engines, demand for which is based on aircraft flying hours. With flights cancelled across the Middle East, aftermarket activity is bound to drop.
But this could be a small setback amid the wider fallout of the conflict. Surging oil prices are pushing up inflation and potentially interest rates. The consequences? Global flight activity could slump if cash-strapped consumers tighten discretionary spending.
2. Slumping engine orders
It’s also important to consider the long-term implications of a near-term airline industry slowdown.
As we saw most recently during the pandemic, carrier profits could sink and with it orders for Rolls’ power units. Not only could this disrupt cash flows and earnings in the immediate future. Lower engine orders could lead to reduced service revenues down the line.
3. Production problems
Energy outlay accounts for less than 5% of Rolls-Royce’s total cost base. So the recent spike in oil prices shouldn’t have an enormous impact on the firm’s earnings.
Yet the Middle East conflict could have significant indirect consequences for the engineer’s production processes. Supply chains — which are already experiencing severe strain — might worsen further if major shipping routes are disrupted, impacting operations and project delivery. Raw material and component prices could also balloon if geopolitical instability rises.
4. Pressure elsewhere
Rolls-Royce famously doesn’t just manufacture and service aeroplane engines. It designs and produces ship engines and industrial power systems across cyclical industries like mining and construction.
It also manufactures lots of hardware for defence customers. But as you can see, a large portion of its business is sensitive to broader economic conditions (roughly 75% of group sales come from cyclical operations). With widely expected interest rate cuts now looking unlikely and economic growth under pressure, will Rolls also see revenues collapse elsewhere?
5. Sky-high valuation
Rolls-Royce is one of hundreds of UK shares whose risk profiles have just shot higher. The thing is, very few of these command the enormous valuation that this FTSE 100 company does. And this leaves it especially vulnerable to a share price correction.
At £12.30 per share, Rolls carries a huge price-to-earnings (P/E) ratio of 36.9 times. That’s miles above the long-term average of 15, leaving plenty of scope (in my view) for fresh waves of selling if news flow worsens.
Bottom Line
I’m not saying things are terrible for the FTSE firm. A quick resolution to the Middle East crisis would change the outlook drastically. It also has excellent barriers to entry and a huge defence business to protect earnings if the worst happens. Not to mention a management team with a proven knack for superb operational execution.
Nevertheless, given its rising risks and high share price, I won’t be buying Rolls-Royce shares for my portfolio. I’d rather look for other shares to buy on the dip.
