Aircraft engine maker Rolls-Royce (LSE: RR) has had a turbulent couple of years. But in the long term, I reckon the Rolls-Royce share price could move up from its current level. Here are three reasons why.
A return to flying
A key reason for the company’s problems over the past few years has been a decline in the number of planes flying as governments scrambled to deal with the pandemic. Civil aviation is one of the main areas of business for Rolls-Royce. Less flying affects it in several ways. Not only are airlines less likely to spend large sums on new engines, they also fly their existing planes for fewer hours. Lucrative servicing contracts are partly based on an engine’s flying hours. So, the slowdown in civil aviation has been bad for both sales and service revenues at Rolls-Royce.
As flying hours return closer to normal, I expect that to be good for revenues and profits at Rolls-Royce. The company reports its full-year results next week. That should give some perspective on the scale and speed of the recovery it expects. But there are positive signs already, such as the announcement today by plane maker Airbus that it would resume its dividend.
Installed base
The economics of the aircraft engine business are attractive in my view. The skill base and cost involved in developing and making engines means only a few companies can do it at scale. That is good for profit margins in the industry. Meanwhile, the lifespan of an engine can stretch over decades. Maintaining it can be a lucrative source of long-term revenues. In its interim results, Rolls-Royce reported revenues of £5.2bn and 56% of that figure came from after-sales services.
Once an engine has been sold, it will need to be maintained – and the experts in maintenance tend to be the people who made it. So I think Rolls-Royce’s large installed base of engines bodes well for its future finances. Servicing them ought to help revenues and profits for years to come.
Robust defence demand
As well as civil aviation, a key driver for financial performance at Rolls-Royce is the company’s defence business. That has been more resilient than civil aviation throughout the pandemic – and I expect it to stay that way for the foreseeable future.
Governments are willing to spend money on military preparedness. As geopolitical tensions persist, I expect that to be the case for years to come. At the interim stage, the company said its defence business had a strong order book.
My move on the Rolls-Royce share price
Although I am upbeat about the prospects for Rolls-Royce, risks remain. Unexpected shutdowns could send civil aviation demand plummeting again at short notice, hurting both revenues and profits. The company’s recent return to positive cash flow is good news, but maintaining liquidity remains critical. Shareholders were heavily diluted in a 2020 rights issue. If positive free cash flow is not maintained, that could hurt liquidity and maybe lead to further dilution in future.
Overall, though, I like the outlook for Rolls-Royce’s business. As recovery continues, I would consider adding it to my portfolio.
