Rolls-Royce confirmed that all three of its divisions performed well over the first quarter. In Civil Aerospace, large-engine flying hours rose by 5% to 115% of 2019 levels.
Defence continued to benefit from an improved aftermarket performance and a more than 20% uplift in new equipment sales.
Power Systems delivered strong revenue growth, driven by high demand for power generation, particularly in data centres. Since the period-end, the group has signed contracts to supply the UK with three small modular reactors (SMRs), which are expected to generate revenues and profits this year.
Full-year guidance was reiterated, with underlying operating profits and free cash flow expected to land between £4.0-4.2bn and £3.6-3.8bn, respectively.
More than £0.75bn of the ongoing three-year £7-9bn share buyback programme has been completed year to date.
The shares rose 4.0% in early trading.
Our view
Rolls-Royce delivered a strong performance across all three of its divisions over the first quarter. The group expects to fully offset the financial impact of the Middle East conflict on its business, so full-year profit guidance was reiterated, and markets reacted positively on the day.
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-called engine flying hours (EFH) are now cruising at 115% of 2019 levels. That figure’s expected to soar somewhere between 130-140% of 2019 levels by the end of 2028.
The Middle East conflict has raised questions about near-term demand, but Rolls claims that EFH of some of its engines in the region has already recovered to pre-conflict levels. Many of the capacity cuts at airlines have been in narrowbody aircraft - a segment of the market that Rolls doesn’t operate in.
From an operational standpoint, contract renegotiations, process changes, component upgrades, and increased use of data to drive efficiencies are reaping plenty of rewards. As a result, margins are continuing to rise, helping to convert the increased flying hours and revenue into profits.
Rolls also has exposure to the defence sector, making up around 25% of group revenue. Given the current elevated-threat environment, defence budgets across many countries are on the rise. With positions in combat aircraft and nuclear submarines, Rolls-Royce looks well-placed to capture some of the increased spending.
The group’s power systems business also accounts for around 25% of revenue. Growth here has been impressive, driven by data centre customers looking for power while awaiting grid connection. With upgrades to grid infrastructure expected to take years, Rolls’ on-site power generation systems look well-positioned to benefit from sustained demand over the medium term.
Despite the positives, some of its newer aircraft engines have required much more maintenance than customers are happy with. Upgraded parts are now being fitted to the affected engines, and early data looks promising. But if the group can’t iron out these issues over the long term, it could eat into future profits.
The balance sheet looks much stronger than it has for some time. That’s given management the confidence to significantly increase dividend payments and start a three-year £7-9bn share buyback programme. But as always, no shareholder returns are guaranteed.
The valuation’s pulled back sharply since the start of the Middle East conflict, which now looks relatively undemanding given its market position and growth levers. However, there’s a decent amount of execution risk, and if management can’t deliver improvements on time, markets are likely to react poorly.
The author holds shares in Rolls-Royce.
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
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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 LSEG. 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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