Rolls Royce has been one of the great turnaround stories of recent years. In October 2020, the stock was languishing at just under 66p a share. Today the share price is around 490p having registered a five-fold increase in under 5-years. So why did the Rolls Royce Share price drop and then rally? And will that rally continue?
Why did Rolls Royce shares fall so hard?
The reason Rolls-Royce shares fell so hard in 2020 is quite simple, COVID.
Rolls-Royce generates the bulk of its revenues from the manufacturing and servicing of Jet engines for the commercial aviation industry much of the firm’s revenue is therefore linked to flying hours.
During the coronavirus pandemic, those revenues dried up, as many planes were grounded by lockdowns and a lack of international travel.
That drop in revenue led to large losses. In 2020, for example, Rolls Royce made a loss of £4.0 billion versus a profit of £306 million in 2019.
The company also experienced a large decline in cash flow from operations, which went negative, coming in at -£4.3 billion in 2020.
With its finances under pressure, Rolls-Royce was forced to raise capital, and in late 2020, it raised £2.0 billion via a rights issue to shore up its finances.
Ultimately, this combination of large losses, negative cash flow, and a capital raise,as well as general uncertainty about when the pandemic would end, had a disastrous impact on the Rolls-Royce share price.
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What turned Rolls Royce shares around?
The recovery in Rolls Royce’s fortunes was down to two major factors:
Firstly, a sharp rebound in the civil aviation market after COVID-19.
Secondly, a rationalisation programme was put in place at Rolls Royce by the newly appointed CEO Tufan Erginbilgic.
According to The International Air Transport Associationg IATA as of December 2023, Global Airline traffic had reached 94.10% of its pre-pandemic levels.
As recently as October 2023 Rolls Royce indicated that it would cut up to 2500 jobs, those losses came on top of 9000 redundancies it made in 2020.
The latest round of job cuts are part of what Mr Erginbilgic describes as:
“A multi-year transformation(al) journey to build a high performing, competitive, resilient and growing Rolls-Royce”
Thanks to Improved market conditions and a renewed focus on efficiency, the company’s profits have risen sharply.
For the first half of 2023, for example, Rolls-Royce reported an underlying operating profit of £673 million – more than five times the figure posted a year earlier.
Whilst at the halfway stage in 2024, it reported operating profits of £1.1 bln up by +74.0% year-over-year and positive free cash flow of £1.2 bln, a rise of +225.0% over the previous year.
The company also guided higher for the full year with operating profits forecast to be in the range of £2.1 to 2.30 bln.
The markets love a turnaround story and the changing narrative at Rolls Royce caught the imagination of investors, at both an institutional and retail level.
During 2024, year-to-date, Rolls Royce’s stock price has risen by +64.50% and it has posted 39 new highs in the process.
The outlook for Rolls-Royce shares
Can Rolls-Royce shares continue to rise from here?
That depends:
As we’ve already noted Rolls Royce’s share price has already had a substantial rise, and the expectations of a turnaround can only carry the price so far.
Operating margins at the group are back to 14.00% and first-half profits after tax came in at £737.0 million up +87.0% over the prior period.
However, the question now is have all the efficiencies available, been wrung out of the business? Or is there more to come?
If it’s the former, then the story becomes all about growing sales. Revenues were up by +19.0% at the halfway stage I note.
If it’s the latter, and the business can become even more efficient than it is today then the shares could continue to appreciate.
After all the return on capital at the business, during H1 came in at 13.80% as net debt fell to £822 million.
However, Rolls Royce is now standing on some pretty demanding forward PE multiples of around 25.0 times, and the stock is only rated as a moderate buy among city brokers, who have a consensus price target of 416.25p.
That’s more than -70p below the current share price at the time of writing.
Some brokers are more optimistic, for example, UBS, which has a buy recommendation and a 640p price target and JP Morgan which has a 535p target pencilled in, alongside an overweight rating.
Either way, the market will be watching closely and expecting Rolls Royce to deliver. If it does then the share price could rise further, but, if it disappoints the markets then things could get ugly again.
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