Rolls Royce (RR Stock) share price slips on slower recovery concerns

It’s been a better year for the Rolls-Royce share price after the declines seen in 2020 saw the shares hit an 18-year low.

This year we’ve seen a recovery of sorts, but it’s been hard-won and has mainly come in the second half of the year, after the company surprised the markets in August with an unexpected H1 profit of £393m, beating consensus expectations of a small loss.

This was helped by a better than expected £600m improvement in free cash flow, which while still negative to the tune of -£1.17bn, was still a significant improvement a year ago.

In the weeks since August, the share price has managed to make some decent gains, although the recent concerns over rising Delta infections and latterly Omicron has seen the shares slip back from their November peaks above 150p.

Rolls-Royce has taken significant steps in the last 12 months to reduce headcount and cut costs and reiterated this morning it was on course with a further £1.3bn of annualized cost.

While all of this is welcome, the reality remains that the business is still heavily reliant for a good proportion of its annual revenue on civil aviation engine flying hours (EFH), and while these have been improving, with the return of transatlantic travel also helping, the company is still set to fall short of its full-year target of 55% of 2019 levels for 2021.

Nonetheless, today’s Q3 update has shown that things are moving in the right direction, the £1.9bn deal with the Pentagon for its F-130 engines which will be used to power the B-52 Stratofortress for the next 30 years, was a notable win. The company also said it became cash-flow positive in Q3 with the result that free cash outflow for 2021 was likely to be less than £2bn previous guidance.

Large (EFH) engine flying hours, which in the first four months of this year were at 40% of 2019 levels, have continued to pick up and have moved up from 43% in the last two months of H1 to 50% of 2019 levels in Q3, which puts full-year hours at 46%, so still below the 55% targeted at the start of the year.

This isn’t altogether too surprising given what’s been happening with the Delta variant across Europe and latterly Omicron, as restrictions get tightened heading towards Christmas.

International travel is likely to remain a headwind particularly as we head into next year, with all the various restrictions imposed by governments unlikely to be materially eased much before early 2022.

On the plus side, the balance sheet is in better shape due to the £2bn of disposals announced in the last few months, including the sale of ITP Aero for €1.7bn which is expected to complete in the first half of next year.

Its Small Modular Reactor (SMR) business is also gaining traction after the government put in £210m on top of £145m of private investment as the company ramps up its contribution to the UK economy’s transition to cutting its carbon output.

As far as its full-year outlook is concerned the company said it is making good progress and has managed to achieve its goal of becoming free cash flow positive by the end of the year, at least for one quarter anyway.

Now they need to do it on a regular basis and while they are likely to come in lower than the previously guided £2bn cash outflow for this year, they still have some way to go to reach their target of being FCF positive of £750m by the end of 2022.

Much of this will depend on when and if international travel returns to normal and that remains a big ask if they are to meet expectations of EFH exceeding 80% of 2019 levels in 2022.

All in all, today's update is broadly positive in that other areas of the business away from civil aviation are moving in the right direction, however, investors seem unable to move past concerns about the return of international travel, with the shares drifting lower in early trade.