2022 has hardly been a banner year for Rolls-Royce (LSE: RR). The share price looks set to end the year markedly below where it started.
For a shareholder in the aeronautical engineer as I am, that is not welcome news. But I continue to hold my shares because I see grounds for optimism that they could move up in 2023 and beyond. Here are a couple of potential positive drivers I see – and one negative one.
Return to normality
The travel market has been turned upside down over the past three years, with demand in the civil aviation market nosediving off a cliff early in 2020. That has had a big impact on Rolls-Royce. Less flying hours mean lower servicing revenues, while airlines struggling to survive are less likely to commit to large capital expenditure like new engines.
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But this year things have got a lot closer to normal. In many parts of the world, civil aviation demand has bounced back strongly. Between July and October, Rolls-Royce reported large engine flying hours were at 65% of their pre-pandemic 2019 levels.
That shows there has been substantial demand recovery – but there is still a lot yet to take place. I think that could happen in 2023 as the travel market returns to normal. If China opens up again fully to the outside world, I expect flying hours to get even closer to 2019 levels.
Meanwhile, Rolls-Royce is now seeing better performance in other business divisions than it did before the pandemic — from power systems to business aviation. That gives the company a solid foundation while the key civil aviation division recovers.
Possible dividend resumption
When it was scrambling to raise cash in 2020, Rolls-Royce took on sizeable debt. One condition was that it could not pay dividends until 2023.
For shareholders used to the company’s regular payouts, that was a nasty surprise. But 2023 is almost upon us. If it meets certain criteria, the firm will be able to pay out dividends again.
I do not know whether it will do so. Even if it does, I think the payout will be a token amount. After all, profits remain thin and the company had around £4bn of drawn debt outstanding as of last month.
But simply, the prospect of a dividend – and what that signals about the business recovery – could help investor sentiment, in my view. That may boost the Rolls-Royce share price.
Share price valuation
But I also see a possible headwind for the shares in 2023 even if civil aviation demand recovers. That is concerns over the firm’s valuation.
The investment case for the engineer is based on its strong position in an industry with few competitors and high barriers to entry.
However, it has been years since that actually translated into healthy, steady profits at scale. The company diluted existing shareholders heavily in 2020 to raise funds. That means each share now represents a smaller fraction of the company – and its profits.
A market capitalisation of over £7bn is a lot for a company that made profits after tax of £124m last year. Unless profitability improves strongly, that price-to-earnings ratio looks high to me. If earnings do not come back at a big enough level, the Rolls-Royce share price could fall.
