Rolls-Royce Holdings Stock: Multiple Tailwinds, Strong Buy

Rolls-Royce Holdings (LON:RR) (OTCPK:RYCEY) has been a perennial underperformer in the past decade. Since 2011, the stock has plunged by more than 50%. Rolls-Royce has also lagged behind its closest rivals like General Electric (GE), Safran (OTCPK:SAFRF), and Pratt & Whitney’s parent company, Raytheon Technologies (RTX).

In 2023, however, Rolls-Royce, which is primarily traded in London, has had a strong start of the year, with the shares rising by over 8%. Other UK stocks as measured by the FTSE 100 and FTSE 250 indices are also outperforming their American counterparts.

Business Overview

Rolls-Royce Holdings is one of the biggest British industrial companies. It operates its business in four key segments. Civil aviation, its bread and butter, accounts for more than 41% of its total revenue. In this segment, the company manufactures aircraft engines, primarily for wide-body aircraft like Airbus A350 and Airbus A330neo.

Unlike other companies in this industry. Rolls-Royce does not make a lot of money selling engines. It uses a razor/razorblade business model where it sells its engines at a loss and then makes its cash through the long-term service contracts it gets from airlines.

Rolls-Royce Holdings does not manufacture engines used by narrow-body aircraft. It made, what I have argued before, to be a strategic mistake of exiting an industry that has boomed in the past few years. Recently, however, there are hints that the company is considering moving back to the industry using its UltraFan engines.

Rolls-Royce is also a major player in the defense industry, where it manufactures products used by militaries in Europe, the United States, Saudi Arabia, and other allied countries. Its products are engines that power aircraft and submarines. The defence business is significantly stable since military spending is usually pegged to economic growth.

The third segment for the business is power systems, which generate about 2.7 billion pounds. Its smallest segment is New Markets, which is taking advantage of the energy transition. As part of this segment, the company is working to launch small nuclear reactors in the UK. It has also partnered with the cash-rich Qatar Foundation to create and scale up climate solutions for the UK and Qatar.

Headwinds Galore

I have covered Rolls-Royce Holdings for several publications like InvestingCube, Invezz, and rkdream.com for a few years now. And for the most part, focus has been on the many headwinds the company has gone through.

Before the pandemic, the company faced a battle of its life when its highly-popular Trent 2000 engine started developing cracks in 2016. As a result, the company had to recall those engines and fix the errors. In the end, the crisis cost the company over $1.6 billion, which is a significantly higher figure considering that the company is valued at $10.6 billion.

This engine problem was worse for Rolls-Royce because of the business model that I have mentioned above. In this model, the company does not make money upfront. Instead, it makes most of its cash in long-term contracts with airlines.

Also, this model sees the company gets a negative cash flow, where it is paid in advance and then delivers the services later. As such, the engine becomes a cash cow after being delivered. But this model only works as long as engines are flying and as long as there are no defects.

After that issue, Rolls-Royce Holdings faced the crisis of its lifetime when Covid-19 hit. As airlines parked their aircraft, revenue from its biggest business dried up. It became a cash incinerator. According to Seeking Alpha, the company’s annual revenue plunged from $21 billion in 2019 to $15.7 billion in 2020. Its net loss widened from $1.7 billion to over $4 billion.

To deal with the crisis, the company announced 9,000 layoffs, issued new shares, and sold its Spanish business known as ITP Aero in a $1.7 billion deal. The company didn’t have a choice. And in 2022, while the aviation industry rebounded, Rolls-Royce’s wide-body engine business lagged that of narrow-body engines as China remained shut off.

Headwinds to Tailwinds

Now, Rolls-Royce’s share price is soaring as these headwinds move to tailwinds. The pandemic-era layoffs, while painful, have left a company that is leaner than it was before. Similarly, exiting its ITP Aero business was a good decision since it helped it prevent more dilution. It also helped it deal with a mountain of debt. It has paid $2.48 billion of debt

The company is starting 2023 with the outlook of the aviation industry looking good with China’s reopening. Many airlines, including Air India, United (UAL), Delta (DAL), and Southwest (LUV) have placed orders of hundreds of planes. While most of those planes are narrow body, the increased orders mean that the outlook for civil aviation is strong. This could benefit Rolls-Royce in the near term. In a note, an analyst at Agency Partners told FT:

“Except for long-haul, civil aerospace is trending towards long-run growth again but in a difficult macroeconomic environment. A lot of the long-haul recovery is still to happen and Rolls-Royce is the purest way of pursuing that,”

Another tailwind is the ongoing war in Ukraine. In its aftermath, many governments have committed to boosting their defense orders. Rolls-Royce could benefit substantially since it is one of the leading players in the sector. In 2021, the company won an order valued at $2.8 billion for B-52 bombers by the American government. And last year, it won another $1.8 billion order for the Navy and Marine Corps aircraft.

Another tailwind is the company’s new UltraFan engine, which was completed in December last year. This engine, which is the largest in the industry, will undergo numerous tests this quarter. It has a 140-inch diameter and is capable of producing 64MW of power. Also, the engine consumes 100% Sustainable Aircraft Engine Fuel (SAF), which is cleaner than the current jet fuel.

This UltraFan engine has no orders yet since aircraft engine manufacturing projects take years to complete. But if it is successful in tests, it could be a game changer in the aviation industry. At a time when demand for wide-body aircraft like A380 is rising, the engine offers a significant opportunity for the company.

Further, I believe that the company will likely use this technology to launch engines for narrow-body engines in the future. This is a major industry that is now dominated by the likes of General Electric and Raytheon’s Pratt & Whitney.

With aircraft orders rising and wait time increasing, the industry has room for another entrant. Rolls-Royce, thanks to its reputation, is the most viable competitor. Some analysts have even theorized that the engine could resurrect Airbus A380 and Boeing 347 with two engines.

Rolls-Royce, like other British companies, is extremely cheap. A good way to value the company is to consider its forward price-to-sales ratio and compare it with some other industrial companies. As shown below, the company is trading at 0.7x forward sales, much lower than the peer average of 2.2x. For a company that is recovering, this valuation seems much lower.

Other tailwinds are the fact that the flight cancellations that we saw in 2022 will likely not happen in 2023 and the cost of raw materials is improving. The company was hit by Russia’s Ukraine invasion because Russia is one of the biggest players in titanium. Further, the company is about to get a new CEO, Tufan Erginbilgic, who is known for implementing turnarounds and bringing down costs at BP (BP).

Rolls-Royce’s Technical Analysis

Regular readers of my work know that I am a believer in technical analysis. In November, I noted that the shares would keep rising for a while. Turning to the daily chart of the company’s London-listed stock, we see that it has been in a strong bullish trend in the past few months. As it rose, the shares moved to the 50% Fibonacci Retracement level. It has also formed a golden cross, which is usually a bullish sign. It is formed when the 50-day and 200-day moving averages make a crossover.

Also, the stock formed an inverted head and shoulders pattern. Therefore, by extrapolating the head and shoulders distance and by using Fibonacci Retracement, we can assume that the stock will rise to about 133 pence, which is about 25% above the current level. This price coincides with the 61.8% Fibonacci Retracement level. It is also the distance between the neckline of the inverted head and shoulders pattern and the head.

Risks to the Thesis

Rolls-Royce Holdings’ recovery faces numerous risks going forward. The biggest risk is its UltraFan engine, which is about to be tested. There is a risk that the engine will not be successful as planned. Also, the company faces numerous capital-intensive programs, including its small nuclear reactors in the UK.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.