The Rolls-Royce (LSE: RR) share price has been one of the great comeback stories of the past three years. So after watching it drop more than 10% in the space of a month, I thought I’d dig deeper.
As I write ahead of Tuesday’s (7 April) market open, the company’s shares are sitting at 1,191.5p — down sharply from the recent highs that had made it a FTSE 100 darling.
So, what on earth’s going on?
Primed for growth?
On the surface, the investment case looks stronger than ever.
Geopolitical tensions are rising. NATO members are scrambling to hit the 2% of GDP defence spending target, with several committing to go further.
The UK government has pledged to lift defence expenditure to 2.5% of GDP by 2027. Defence contractors have rarely had a more favourable political environment.
Given the company’s strong market position as a manufacturer of engines for military jets, nuclear submarines, and power systems for naval vessels, it seems to be in a great position.
Surely the company should be riding this wave? And yet the price-to-earnings (P/E) ratio has contracted, not expanded, in recent weeks.
The civil aerospace complication
Here’s the part of the story that gets overlooked. The majority of the company’s revenue doesn’t come from defence at all.
Civil aerospace is the biggest money-maker, underpinned by long-term service agreements tied to its wide-body aircraft engines.
Under this model, the company earns fees based on the number of hours those engines fly. More flight hours mean more revenue. Fewer hours mean less.
That’s created a problem in recent weeks as conflict in the Middle East has hit the aviation industry hard.
Travel hours have been significantly reduced as airspace remains restricted. Airlines operating routes between the US, Europe, and Asia are already reassessing capacity.
Iran’s control over the Strait of Hormuz has sent crude oil prices soaring and created uncertainty over global aviation supplies.
All of this has clearly worried investors. The Rolls-Royce share price has fallen 12.6% in the past month as investors try to price in the uncertainty and potential impact on the company’s future prospects.
My verdict
The Rolls-Royce share price has been under pressure of late. However, it’s worth zooming out from the current uncertainty to see the bigger picture.
The company’s shares are still up nearly 1,000% in the past five years and it’s a Footsie top performer with a market cap over £100bn. The company remains on a compelling turnaround journey with a strong order book and a credible management team.
Sure, the outlook is less clear than it was a month ago. However, I think the recent turbulence and broader market uncertainty is understandable.
For patient investors with a long-term horizon, the recent pullback could be a chance to consider snapping up some shares for a cheaper entry point and it could be worth a closer look.
