Until a few days ago, things were looking good for investors in Rolls-Royce (LSE: RR) like myself. Rolls-Royce shares rose over 70% between October and late last month.
But the past few days have seen the shares starting to slide again, losing 7% in five days. That followed widely reported downbeat comments by the new chief executive less than a month after he put his feet under the desk.
Good recent run
The increase in the value of Rolls-Royce shares before the demotivating pep talk reflected growing optimism about the outlook for demand in civil aviation. The world has been opening up, with the last major pandemic-era holdout of China recently relaxing many of its restrictions.
Closer to home, airlines are on a tear. In their most recent reported quarterly results, British Airways’ parent IAG and easyJet both saw revenue slightly higher than in the equivalent pre-pandemic 2019 quarter. Ryanair and Wizz far surpassed their pre-pandemic revenue.
I think that helps explain the recent surge in Rolls-Royce shares. Soaring air travel could lead to higher demand for new engines and bigger servicing revenues from the firm’s installed base.
Bottom line concerns
But in an industry selling costly products such as aircraft engines, revenues have not been my primary concern for the company. Rather, it is converting them into profits. The top line last year at Rolls was £11.2bn which, although still well below the 2019 equivalent of £16.6bn, is still substantial.
But the post-tax profit was £124m, making for a measly profit margin of 1.1%. That leaves little room for error and is not appealing to me as an investor. Last year’s profit followed three consecutive years of heavy losses at the engineer.
Often profit margins can be improved by cutting costs in a business and the new chief executive seemingly plans to do this. But the company already had a large cost-cutting programme in 2020. In a highly skilled, capital intensive industry where a reputation for quality is crucial, cutting costs involves a careful balance.
On top of that, I fear that cuts could lead to staff dissatisfaction at a time when wage inflation is already a big risk to profits at the company.
My move on the shares
In other words, as an investor, I am nervous about the aggressive seeming new tone of Rolls-Royce’s new leader, especially when addressing an internal audience to most of whom he is still a stranger.
If the chief executive can prove that his approach helps the company to boost profitability dramatically, I think Rolls-Royce shares could respond by moving upwards again. So the recent share price reversal may only be temporary.
But there is substantial executional risk. Making a workforce feel nervous about job security just weeks into running a firm does not seem to me like a smart way to run a business.
For now, I plan to keep my shares. I think the company’s installed base and expertise in an industry with high barriers to entry could hopefully form the basis of future success. But I will be keeping an eye on whether the firm’s leadership helps its recovery, or simply hollows the engineer out for short-term financial gains to the potential detriment of the long-term investment case.
