Can the Rolls-Royce rally continue?

Four years ago, Rolls-Royce was forced to ask shareholders for money and cut 9,000 jobs to cope with the crisis caused by the Covid-19 pandemic.

Last week, the leading British engineering firm announced a 74 per cent rise in half-year profits, a resumption of dividend payments and a giVscek of 150 shares per employee, marking one of the most extraordinary and rapid turnarounds in recent UK corporate history.

The sharp turnaround in its fortunes coincided with the arrival of Tufan Erginbilgiç, who took over in January 2023. Rolls-Royce shares have more than quadrupled in that time, outperforming most major indexes.

The company’s turbocharged performance means it is already past the halfway point towards Erginbilgiç’s 2027 annual profit and cash flow targets; Rolls-Royce now expects to achieve more than 75 percent of its target for annual operating profit of up to £2.8 billion and more than 65 percent of its target for free cash flow of up to £3.1 billion by the end of this year.

While his predecessor, Warren East, successfully led the company through the pandemic, Erginbilgiç, who described Rolls-Royce as a “platform on fire” upon his arrival, moved quickly to revamp senior management, reduce duplication and trim middle management.

The rapid transformation of the 118-year-old manufacturer, whose recent history has been marked by sharp ups and downs, has raised questions about how long Rolls-Royce’s current winning streak can last. Can the former oil executive deliver on his promise to transform the company into a “high-performing, competitive and resilient business”?

Erginbilgiç admitted that the rate of recovery would not be linear, but argued that the group’s medium-term goals should be seen as a “milestone, not a destination”.

“There is a very exciting and more profitable growth story beyond the medium term,” he said.

He dismissed suggestions that part of the recent success was due to the return of international air traffic aVsceker the pandemic, which brought travel to a virtual standstill. Rolls-Royce’s largest division builds engines for the world’s largest passenger jets, but makes most of its money from servicing and maintaining them while they’re in service.

“This is not a story about flight hours, this question should go away,” he said. The company, he argued, was instigating real change, cutting costs and expanding the “cash potential and quality of the civilian business.”

Rolls-Royce has renegotiated loss-making customer contracts to boost profitability and will invest more than £1bn over the next few years to improve the durability and performance of its Trent family of engines that power long-range passenger jets such as the Boeing 787 and Airbus A350.

Analysts said the civil business’ performance in the half stood out. Engine flight hours, a key metric since the company makes most of its money when its engines are running, returned to pre-pandemic levels while margins in the business rose 18 percent in the six months.

The new management had “made more profit than people expected…[they] achieved more than the old Rolls-Royce would have,” said Nick Cunningham, analyst at Agency Partners.

The “structural change,” he added, “is partly about managing the company more rigorously, with a clear set of guidelines about what you’re trying to achieve.”

Insiders speak of the “pace and intensity” Erginbilgiç has brought to the company, much of which is evident in the rigorous, regular reviews he holds with senior executives, where clear goals are set.

He had instilled a “sense of commercial mentality… not only through the civilization but through the entire organization and [has] has maintained the costs that the company had incurred during Covid,” said Harsh Jhaveri, an investment analyst at Orbis Investments, which acquired Rolls-Royce in 2016 and owns 0.5 percent of the company.

While much of the focus has been on improving Rolls-Royce’s commercial aircraVscek division, other businesses have also recovered. The underperforming power systems unit, which makes diesel and gas engines for ships as well as power generators for data centers, has recovered.

Last week’s half-year results showed the division’s underlying operating profit rose 56 percent to £189 million. Its underlying operating margin rose to 10.3 percent, with expectations for further improvement in the second half.

In the defence sector, Rolls-Royce has won some major contracts and is expected to benefit from increased government spending, including on the Aukus submarine programme with Australia and the United States.

In the medium term, the big strategic challenge will be how the company can re-enter the lucrative short-range narrow-body market. Rolls-Royce leVscek that sector more than a decade ago when it pulled out of a joint venture with Pratt & Whitney of the United States. The British company recently began work on a demonstrator of its Ultrafan engine, which would be specifically designed to power a next-generation narrow-body jet.

Erginbilgiç said he was talking to Airbus and Boeing about the engine. Instead of developing and building it himself, he would prefer a partnership with another company, he added.

Despite the company’s strong performance, there are some clouds on the horizon. Supply chain challenges across the industry could persist for another two years. Rolls-Royce’s cash flow forecast for the year includes a massive £200m impact from supply chain issues.

There are also some early signs of pressure on airline earnings, a measure of average ticket prices that takes into account the number of passengers and distance traveled. Most aerospace executives insist it is too early to talk about a decline in traffic growth and thus demand, but the biggest test of whether Erginbilgiç’s transformation has paid off will likely come with the next industry crisis, and whether it has made Rolls-Royce more resilient.

Most analysts reiterated their “buy” ratings on the company last week, saying there was still a lot to look forward to despite the shares trading at around 25 times next year’s earnings.

Berenberg analyst Philip Buller, who downgraded the stock to “sell” earlier this year, admitted his decision was too early, given the shares’ 50% rise since January.

He credited Erginbilgiç and his team with “exceeding expectations” in terms of cost control, but argued that investors should look beyond 2027. “What happens to the cash aVsceker 2027… and is there anything else in between that could spoil the party, like weakening air traffic?”

The stocks, he said, were now priced for “this very nice moment in all end markets to be a permanent feature.” However, “history tells us that this is not normally the case,” he cautioned.