Rolls-Royce shares: why management is investing more in power systems

Although Rolls-Royce (LSE:RR) has bled a lot of money this year due to the pandemic, the company has shored up its balance sheet lately. In October, RR raised £5bn in extra liquidity through a rights issue and bond issuances. 

Analysts expect air travel to increase over the next few years with the distribution of Covid-19 vaccines. As a result, things could return closer to normal for the company by 2022. Indeed, management expects to target free cash flow of a minimum of £750m free cash flow in 2022, which is actually higher than the company’s core free cash flow in 2018. 

As a result of the anticipated normalisation, the company is going on the offensive and planning to expand. 

In terms of where the company plans to focus, Rolls-Royce CEO Warren East recently said that he plans to invest more in the company’s power systems going forward.

Power systems division

RR’s power systems division is a big business. It’s a leading provider of medium speed and high speed reciprocating engines. It also provides power generation and complete propulsion systems. 

According to the 2019 annual report, power systems is second-largest division after civil aerospace. It accounted for 22% of underlying revenue last year. 

The division is also profitable and growing before the pandemic. According to the report, it generated £357m in underlying operating profit in 2019, up from an adjusted £315m in 2018.  

It’s also pretty resilient. Despite the pandemic, the division reported an adjusted underlying profit of £22m for the first half of this year. One reason for that resilience is that RR realizes relatively stable demand from servicing its existing installed base of engines. 

With its resilience, profitability, and the future impact of new technologies, management is looking to invest more in the division. Given the tough aerospace outlook in the next few years, management has said they will likely focus R&D more on the power systems business than aerospace. 

Lately, management has expanded digital solutions in its power systems division, offering customers more utility. Digital solutions can often generate more useful data and potential insights. In the future, management has committed to becoming more green. According to the company’s 2019 annual report, the company has increased “spend on hybrid, gas, and hydrogen technology development“.

Rolls-Royce shares: is the stock a buy?

Although Rolls-Royce operates in the industrials sector, I think RR is also a technology company. Given the complexity of making jet engines that are safe, fuel efficient, and long-lasting, I would argue the jet engine business is about as high tech as any nearly any business out there. 

With its world-class R&D workforce, I reckon the company has a shot at succeeding in creating new power systems products that could be in high demand. If RR’s R&D initiative pays off and management executes well, I think Rolls-Royce shares could certainly go higher in the long run. 

I like Rolls-Royce, but given the current valuation, I’m adding the share to my watch list. I’ll buy if the price dips lower.