Key points:
- Given the revival of air travel, we’d expect Rolls-Royce to be doing well
- That isn’t how informed opinion has it though
- JPMorgan has just downgraded RR shares
- Have Rolls-Royce Shares, RR, Recovered Enough There Could Be A Bid?
Rolls-Royce (LON: RR) shares we’d expect to be doing rather well at present. The airlines are reporting that passenger traffic is returning, even that there’s pent-up demand. So, we’d expect the company that makes the engines that power the flights to be doing well. Rolls-Royce shares aren’t doing well, though so what’s the story here?
This is especially puzzling as the heart of the RR business is not, in fact, the sale of engines. That’s much more like the razor business where you give away the handle in order to sell a constant stream of new blades. Not quite, of course, engines are very expensive things themselves. But it’s the ongoing stream of maintenance revenue that really drives Rolls-Royce. This is charged per hour in the air so, airlines are getting their fleets back up into that air and those revenues should be surging.
JPMorgan Cazenove seems to disagree and their downgrade today of Rolls-Royce shares to “underweight” seems to have been the trigger for today’s 6% fall. As we’ve noted before, the price has recently been buoyed by gossip – and it’s nothing more than gossip perhaps – of a bid that might emerge. The target price for RR now is only 75p in this particular analysis.
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The argument being put forward is that sure, Rolls-Royce has interesting new business opportunities away from the jet engine business. Electrical power for small aircraft, modular nuclear reactors, there’s definitely something there. But these are not just new products, they’re entirely new markets. Those take time to develop, especially when product meets new market regulation – exactly what will likely be the major hurdle to overcome here. That means that while the long term prospects might be good, even excellent, it’s possible that the “new markets” division will be loss making right into the 2030s.
The end result of this analysis is that earnings per share estimates are down by as much as 77% for this current financial year to 25% for 2025. That’s around 15% below current market expectations.
Now, whether this analysis is correct or not is another matter. It’s also slightly odd to see diversification being treated as an increase in risk to Rolls-Royce shareholders. But depending upon how much capital these new products do swallow before they meet the market that could indeed be true. Not that we all really want to be reminded of this but RR did have to be taken over by government those decades back precisely because it spent too much on developing a new product – the RB211 engine.
The result of this analysis – whether it’s correct or not – is that a resurgence in the civil business – those jet engines – as covid recedes and travel resumes doesn’t really solve the problem identified. For the problem being worried about at RR isn’t in fact with the jet engine business at all.
There does come a point at which the RR share price becomes low enough that buying to ride until those new businesses come good makes sense. But what that price is is a matter of conjecture at this point.
