Rolls-Royce: Positive Earnings Report, Progress In Decarbonization Projects (RYCEY)

After a 132.5% price rise over the past year, aero-engines manufacturer Rolls-Royce (OTCPK:RYCEY) (OTCPK:RYCEF) might look like a stock to proceed with caution on, especially as uncertainty persists in key global economies and the stock markets are getting wobbly. But it isn’t.

Consider this. Just before the pandemic, at the start of 2020, it was trading at 45% higher levels to where it’s at now. However, the impact to its big civil aerospace segment, in particular, during COVID-19 well and truly took the wind out of it.

It has recovered now, and if it stays on this trajectory, a steep continued price rise isn’t inconceivable. Especially not since financials are robust, as was confirmed by its first half (H1 2024) results in earlier this month. Further, it’s playing a part in advancing the fast-growing decarbonisation economy, the key focus here on Long Term Tips. This can hold it in good stead even in the long term.

Robust financial performance

First, a look at Rolls-Royce’s latest financial performance. There’s much to like about it. Here’s why.

#1. Healthy revenue growth: Even as its underlying revenue growth has slowed down slightly from the 21% seen in 2023, it remains strong at 19% year-on-year (YoY) in H1 2024 (see table below). It’s supported most strongly by the civil aerospace segment, which is particularly important since it brings in half the company’s revenues. The segment grew by 27% YoY on strong original equipment deliveries. The defence segment was strong too, with 18% YoY revenue increase, while power systems lagged behind with just 6% YoY growth.

#2. Margins improve: With even stronger profit growth compared to revenues, the profit margins improved, with the gross margin at 24% compared to 21% for the full year 2023 while the operating margin rose to 14% from 10.3% last year. Following from this, the net profit margin also rose to 9% from 7.4% in 2023.

#3. Upgraded outlook: Rolls-Royce also upgraded its operating profit guidance. It now expects the underlying figure to range between GBP 2.1-2.3 billion, a 19% increase at the midpoint from the earlier range of GBP 1.7-2 billion.

Stock Metrics: Dividends and Market Multiples

Coming to the stock metrics, the first point to note is the dividends. After five years, Rolls-Royce will also start paying dividends again. It expects a dividend payout ratio to be 30% of the underlying post-tax profit in 2024 and sees a 30-40% payout ratio after that.

Assuming that the ratio of net profit to operating profit remains constant for the full year 2024 at H1 2024’s level of 64.1% and that operating profit is at the midpoint of the guidance range, the expected underlying net profit for the year will be GBP 1.4 billion (USD 1.8 billion). This indicates a forward dividend yield of 1%. This isn’t significant, but it does add to the stock’s potential returns.

The estimate for net profit also results in a forward non-GAAP price-to-earnings (P/E) ratio of 29.2x. This looks rather good compared to the stock’s five-year average of 42.75x, and indicates ~45% upside to the RYCEY even now. Incidentally, if this rise were to happen, it will bring the stock right back to where it was pre-pandemic.

Progress on decarbonisation goals

But it’s not just the here and now that makes Rolls-Royce interesting. It’s also the company’s focus on the future, with its green economy focus. Before anything else, in contributing towards decarbonisation, the company targets achieving net-zero from its operations by 2030. It has already made progress toward this end, with 40% reduction in greenhouse gas emissions [GHGs] in the past decade.

There’s far more, though, with key recent developments that move the needle forward in supporting the global goals towards net-zero emissions as well. Here’s how:

• In the civil aviation segment, the company is developing a hydrogen fuel compatible engine, which will be tested at NASA’s Stennis Space Center in Mississippi. All its engines are already compatible with sustainable aviation fuel.
• The power systems’ segment, which brought in 22.5% of the H1 2024 revenues, made progress in battery storage. Specifically, with regard to its mtu EnergyPack, which integrates solar and wind power (see graphic below). In May, the company said it was going to provide large-scale battery storage to the German renewable energy producer Encavis (OTCPK:ENCVF).

• The new markets segment, which includes the development of small modular reactors [SMRs] also made progress towards nuclear energy. It has proceeded to the third and final stage of the generic design assessment underway, through which the UK’s nuclear regulators assess aspects like safety, environmental standards, and waste management. With the UK having elected a new government, there were some concerns whether it will proceed at speed on previous projects. But with the latest development since, that fear is assuaged, which is another positive.
• The company could also provide SMRs to Sweden. It’s among the two companies to be shortlisted by the country’s renewable energy producer, Vattenfall, towards the end.

Investing takeaways

The key investing takeaway here is that Rolls-Royce looks like a good buy from both the short-to-medium term perspective and also has long-term potential.

As of now, there’s significant price upside to it based on the latest financials. Robust profit growth indicates that its forward P/E looks good compared to past levels. Moreover, dividend reinstatement is a sweeter, even though the forward dividend yield is low.

It also continues to take steps towards developing energy innovations for tomorrow. From hydrogen fuel to renewable energy storage and SMR development, the company has made progress in recent months alone on these fronts.

This isn’t to say that there can’t be bumps along the road. With economies like the US and China facing macroeconomic uncertainty, an impact on the civil aerospace segment can’t be ruled out if things get worse. The segment is dependent on air travel, which is vulnerable to cyclical fluctuations. It’s most unlikely that any impact will rival what the company faced during the pandemic, but it could impact the earnings outlook a bit. Also, the green economy innovations might or might not work out. Only time will tell.

But right now, all’s well for RYCEY. I’m going with a Buy rating.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.