Rolls Royce's current trading is in line with full-year guidance, with the group expecting underlying operating profit and free cash flow of £1.2-1.4bn and £0.9-£1.0bn respectively.
Based on a 2027 time frame, mid-term guidance has been set with the group targeting a "step change" in performance. By this point, Rolls Royce expects to deliver an annual operating profit of £2.5-2.8bn, at an operating margin of 13-15%. Free cash flow is expected to be in the £2.8-£3.1bn range.
Mid-term operating margin targets have also been set across its major divisions. Civil Aerospace is set to see the biggest improvement, moving from 2.5% in 2022 to 15-17%. Defence and Power Systems margins are set to improve to ranges of 14-16% and 12-14% respectively.
Over the next five years, the group plans to sell around £1.0-1.5bn of its assets and re-allocate the funds to areas of the business where it thinks it can generate more value.
The shares rose 4.2% following the announcement.
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Our view
Rolls Royce has announced its medium-term targets to the market, with sights firmly set on a step-change uplift in performance. We think these targets look achievable, with the potential to outperform some of them if it can nail its execution, especially in the Civil Aerospace division.
Rolls Royce produces aeroplane engines for larger, long-haul planes. A huge amount of its revenue comes from servicing those engines, with business based on how many hours those engines spend in the air.
So it was encouraging to hear so-called engine flying hours (EFH) grow to 86% of 2019 levels. EFH isn't expected to return to pre-pandemic heights until the end of 2024, and until that happens, there's a ceiling to how high Rolls Royce can fly.
Disposals and a huge restructuring effort have lightened the load of recent financial scars, and the transformation programme's showing early signs of success too - driving productivity improvements across the group's major divisions. More disposals are on the cards, with Electrical division likely first on the chopping block as the group looks to free up cash for other parts of the business.
Free cash flow jumped up to £356m at the half-year mark - seven times higher than markets had originally been expecting. That comes despite Rolls spending more cash building up its inventory levels to cope with the additional activity and constraints in supply chains.
Now it's back in positive free cash flow territory, Rolls has made good headway in pushing debt lower. But last we heard the group was still sporting a negative equity position - meaning liabilities outweigh assets - so we're sceptical about seeing any kind of dividend this year. Longer term, if cash flows keep improving then there could be scope to put dividends back on the table, but as always there are no guarantees.
Rolls' position in the defence and aerospace industry is enviable - high barriers to entry mean there are very few smaller competitors sniffing around. And a multi-billion pound order book gives the group a good deal of visibility over future revenue.
However, valuing that long-term opportunity is a challenge. Huge asset write-downs mean traditional valuation metrics - like Price/Book or Price/Earnings - don't tell the full story. For that reason, we've used Rolls' Price/Sales ratio in the box below to offer a valuation touch point as it indicates how much the market is willing to pay for each pound of expected sales. But it's not a perfect indicator since it doesn't account for debt or profitability - both of which are still major points of focus for Rolls right now.
It looks like the worst is now over, but there's still plenty of work to be done. With no dividend currently on offer to make the wait more palatable, shareholders should be prepared to stomach some turbulence.
Environmental, social and governance (ESG) risk
The aerospace and defence sector is high-risk in terms of ESG. Product governance and business ethics are key risk drivers. Carbon emissions from products and services, data privacy and security and labour relations are also contributors to ESG risk.
According to Sustainalytics, Rolls Royce's management of ESG risk is strong. It has set up a safety, ethics & sustainability committee to oversee ESG issues and executive compensation is tied to performance on these issues. There is also a strong environmental policy, including a commitment to net zero and interim targets, and whistle-blower programme. However, ESG-related disclosure falls short of best practice.
Rolls-Royce key facts
All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
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