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Article summary:
- Rolls-Royce’s share price has surged 70pc since January, outperforming the FTSE 100 index.
- The company reported an 18pc sales increase and a 71pc rise in operating profits.
- Rolls-Royce plans to reintroduce dividends and expects significant profit growth amid rising defence spending.
When Questor last discussed the prospects for Rolls-Royce, our headline stated “there’s more mileage in these shares – but don’t get carried away”. Since expressing that view in January this year, the aerospace and defence firm’s share price has soared 71pc higher.
Although we were right to remain upbeat about the stock’s capacity to generate further capital growth, we were clearly far too cautious in our assessment. We felt that the company’s share price already factored in a substantial proportion of profit growth potential having surged higher in the preceding months.
Still, investors who followed our original “buy” tip from October 2018 are now up 77pc. This compares favourably to a 13pc rise for the FTSE 100 index over the same period. Having recently released yet another set of strong results, there is little reason to change our view that the company’s shares offer long-term capital growth and index-beating potential.
Sales in the first half of the year rose by 18pc, while operating profits were up by 71pc on the same period of the prior year. The latter figure benefitted from higher profit margins, which rose by 430 basis points to 14pc at the operating level. This is a substantial increase and highlights that the firm’s revised strategy is making a significant impact on its financial performance.
Profit margins were boosted by the company’s ongoing cost-cutting programme. It is on track to deliver £250m of cumulative savings by the end of the current year, while a medium-term target of between £400m and £500m remains in place. The firm also raised prices in its defence and power systems segments during the first half of the year, which further helped profit margins.
Rolls-Royce’s improving financial performance prompted it to raise guidance for the full year. It now expects to deliver operating profits of £2.1bn to £2.3bn versus a previous forecast of £1.7bn to £2bn. It also announced plans to reintroduce a dividend in the current financial year following a five-year hiatus. It expects to distribute 30pc of net profits to shareholders this year, with that figure set to occupy a range of between 30pc and 40pc in future.
In addition, the company’s financial position is improving. Net debt declined by 58pc during the first six months of the year so that it amounts to £831m. Alongside rising profits, this means the company’s net interest payments were covered a very healthy seven times in the first half of the year.
This figure is likely to grow as the company’s operating outlook improves. Its defence segment is set to benefit from persistent elevated geopolitical risks that have already prompted a radical shift in attitudes towards military spending across a wide range of countries.
For example, 23 out of 32 NATO members are set to meet a target to spend at least 2pc of their GDP on defence this year. This compares with just three members who met or exceeded the target a decade ago.
An improving economic outlook amid interest rate cuts in the US should further benefit the company’s defence segment, as well as its civil aerospace business. Faster economic growth is likely to prompt stronger demand for air travel as disposable incomes rise, thereby equating to growing order volumes for the firm’s engines. Indeed, the International Air Transport Association forecasts that global passenger numbers will rise at an annualised rate of over 6pc in the three years to 2027.
By the end of that period, Rolls-Royce expects to generate annual operating profits of £2.5bn to £2.8bn. If met, the midpoint of those figures would represent growth of 67pc versus last year’s level.
With the company’s shares currently trading on a price-to-earnings ratio of 38.3, there is scope for them to deliver further capital growth as profits rapidly rise over the coming years. With longer-term growth opportunities present across its power systems segment and in new markets, Rolls-Royce’s investment potential remains impressive.
Clearly, there is scope for short-term difficulties caused by factors such as supply-chain challenges and the impact of time lags following interest rate cuts. They could prompt temporary share price weakness in the coming months. But, fundamentally, the company remains sound and has a solid strategy. We remain upbeat regarding its future prospects.
Questor says: buy
Ticker: RR
Share price: 526.6p
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