Following today’s market update, the Rolls-Royce (LSE: RR) share price continued its recent downward trend. However, it still remains one of the most commonly traded shares on the Hargreaves Lansdown platform. It’s not hard to see why. Its competitive advantage is undoubtedly its engineering heritage. But when I am looking at potential companies to invest in, I try to remove emotion from the equation and look objectively at the prospects for the business in the future.
Rolls-Royce operates in an environment where there are significant barriers to new entrants – both in terms of capital and technical capability. After all, assembling engines for the aerospace industry or constructing power systems for industrial markets is not a feat that could be easily replicated by any potential new entrants.
Although Rolls-Royce is a diversified business with significant operations in defence and power systems, the largest chunk of its revenues (41%) comes from the aerospace division, and in particular from its long-term servicing agreements (LTSA). It doesn’t take a genius to work out that the onset of the pandemic has ruthlessly exposed the risks inherent in such a business model.
Why I continue to remain cautious about Rolls-Royce
For the last 18 months, Rolls-Royce has been in survival mode. It has, and continues to, slash costs. Every time it updates the market, the same key themes keep recurring: restoring its battered balance sheet; improving its free cash flow position; disposing non-strategic assets to improve liquidity; and reducing employee headcount. All good you might say. But what I don’t see much evidence of is how Rolls-Royce will know when it has done restructuring.
Today’s update reinforces my belief that Rolls-Royce continues to view engine flying hours (EFH) as part of its core long-term strategy. But what if they are wrong? What if air travel (particularly long-haul) never returns to pre-pandemic levels? Does it continue to dispose of assets from the business in a desperate attempt to transition to a business model that is more reliant on original equipment sales than LTSAs? Will it need to tap investors for further funds or borrow more money?
Even if EFH do recover to pre-pandemic levels, I still see significant risk. In an attempt to survive through the pandemic, it has shed so many assets (both human and physical) that it is impossible for me to judge how much of this fat-stripping exercise has also carved away muscle too.
At some point, Rolls-Royce will need to transition from a business that is restructuring to one that is capable of reconceiving itself, of regenerating its core strategy. In short, of getting different. I see some evidence of this. The ‘Spirit of Innovation’, its all-electric aircraft, on a recent test-run reached a speed of 387mph. In conjunction with other parties, it is also designing small modular reactors in order to provide affordable, scalable and low-carbon power solutions. These reactors could be online as early as 2030s.
However, with the core of its business so inextricably linked to the aviation industry and with so much near-term uncertainty, I still remain to be convinced that it is a business worth investing in. For now, it remains on my watchlist.