Rolls-Royce Stock: Possible Earnings Increase (OTCMKTS:RYCEY)

Introduction

Demand for aircraft, post-pandemic, is greater than supply due to a combination of traffic growth and fleet retirements, while the supply chain is still complicated by Boeing’s safety concerns ( BA) and Airbus (OTCPK: EADSF).) almost at full capacity. In addition, the engine is reminiscent of an RTX at Pratt Whitney (RTX) company plus production delays at Rolls-Royce Holdings (OTCPK:RYCEY) and GE Aerospace (GE) provide the sector with pricing power that is expected to increase profits through 2026. This was collaborated by research on Embraer (ERJ), the company said the decline in deliveries during the 2022-2023 period was due to delays from its engine supplier, Rolls-Royce, which led me to investigate and analyze the company.

Performance

RR (Rolls-Royce) has significantly underperformed its peers and customers over the past 10 years and at one point during the pandemic was down almost 90% before the share issue, the change of direction and restructuring. Note that the share price is in sterling and does not reflect the Brexit-induced devaluation of the currency.

What is Rolls-Royce

The company designs and manufactures complex power and propulsion systems such as commercial and combat aircraft engines, ship and submarine propulsion systems, and industrial generators. RR has three business groups: Civil Aerospace with 50% of the turnover, followed by Defense & Power Systems with 25% each. The small nuclear reactor (SMR) JV is more of an R&D project than an operating company.

The civil aeronautics sector is the one that gets the most attention, with the demand for aircraft being greater than the supply, as mentioned previously. RR is the smallest with a share of 18%, while GE dominates with 35% directly out of 55%, including all of CFM (JV with Safran). Pratt Whitney was negatively impacted by its global recall that grounded hundreds of planes. According to market research, demand for civil aircraft could grow by more than 7% in the long term.

Most aircraft are designed with a specific engine, meaning they are not normally interchangeable. Thus, the demand for new engines and subsequent long-term services and parts depends on the success of an aircraft platform or model. The Boeing Max 737 uses a CFM LEAP 1-B engine and could see demand and revenue decline if that platform loses to the Airbus A320, which offers two engine options from CFM and Pratt Whitney. RR focuses on the widebody and executive market with engines for the A330, A350 and Boeing 787 for example.

Timid reversal of consensus

After the pandemic, the company began a restructuring process that yielded excellent results that were reflected in the stock price, but consensus forecasts remain conservative. The company’s forecast, which could be increased in the half-year performance report on August 1, 2024 (UK companies are not required to publish quarterly results), calls for an increase in EBIT margin to 13-15% from 10%. % in 2023 and 5% in 2022 for £2.5 billion to £2.8 billion in the medium term. The consensus forecast is £2.5 billion by 2026, or an EBIT margin of 13.3%, which leaves room for improvement. The aircraft manufacturing supply chain has gained pricing power due to increased demand, as previously mentioned, and RR could gain market share.

At the same time, the defense segment is unfortunately expected to benefit from increased NATO spending following the invasion of Ukraine, while the electricity segment (industrial generators) could see a increased demand as power grids become overwhelmed by hot summers and AI chatbots.

Assessment

The stock surpassed the consensus price target of GBP4.6, which translates to an implied P/E (cash) of 17x or 1.1x PEG. Note that I value capital-intensive companies based on cash profits, which is net income plus depreciation. Assuming RR can provide consensus estimates in 2025, I calculate a price target of GBP5.8, or +19% potential upside. I believe all three of the company’s business segments have strong demand and can produce pricing power and better-than-consensus results that could lead to valuation increases.

Peer compositions

I compared RR to a set of aerospace and defense stocks to assess its relative growth and valuation, which, as the table and chart below show, are attractive, if not a bargain. The company is showing online revenue growth, but margins below the industry (restructuring underway) and cash profit growth nearly twice the 2025 average.

Risk

The biggest risk to the business case is the inability to continue to execute the turnaround and meet forecasts, which could result in a sharp correction in the stock price. Grounding of aircraft on RR platforms or recall of engines could result in loss of market share and lower margins. A decline in consumer demand for air travel, for example due to soaring oil prices or geopolitical tensions, can fundamentally change the jet engine market.

Conclusion

I consider Rolls-Royce a buy. Despite the recovery and the stock price beating consensus, I think there could be room for an upward revision to earnings and guidance after the interim results report. The company’s three business segments, namely civil aircraft engines, defense engine power systems and industrial generators, enjoy strong demand and pricing power. Finally, the valuation, according to conservative estimates, is not expensive relative to growth or its peers.

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