The latest boost to the Rolls-Royce (LSE:RR) share price came after its capital markets day earlier this week. The stock jumped 5%, taking its gains for the year to 172%.
As a result, the company’s shares are closing in on their pre-pandemic levels. And there are reasons to think there might be more to come.
Reasons for optimism
The first reason for optimism about the Rolls-Royce share price is that air travel still hasn’t fully recovered to its pre-pandemic levels. Specifically, engine flying hours are still down 14%.
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This is what drives servicing revenue, which is the core of the company’s profitability. So there’s reason to believe the recovery isn’t yet complete.
A second reason is the company looks set to strengthen its balance sheet in the near future. In 2022, around 50% of Rolls-Royce’s operating income went on interest payments on its loans.
Over the next five years, though, the firm is planning between £1.1bn and £1.5bn of disposals. This should help its financial position, reducing the threat of having to refinance at higher interest rates.
Third, the business has some ambitious free cash flow targets. In the medium term, Rolls-Royce is aiming to generate between £2.8bn and £3.1bn per year.
With the company’s market cap currently £22.6bn, this would represent an annual cash yield of between 12% and 14%. In that scenario, I think the stock market would justifiably bid up the shares.
Potential headwinds
In my view, there are clear reasons for thinking that the Rolls-Royce share price can keep going higher. But investors ought to be aware that there are also risks that should be considered.
One is the macroeconomic environment. While flying hours are still some way short of 2019 levels, demand for travel might suffer in an economic downturn.
This will make it harder for the company to reach its medium-term financial targets. Even if it’s just a matter of time, a slower recovery means investors are likely to have to wait for their returns.
Another issue is the uncertainty around the company’s plan to right its balance sheet. The company is aiming to raise between £1bn and £1.5bn but this isn’t entirely under its control.
CEO Tufan Erginbilgic has stated that the firm will only sell assets at prices it considers acceptable. But this might not be possible, depending on how market conditions develop.
Investors should therefore be careful with Rolls-Royce shares. The company definitely has scope for growth, but paying ahead of time is a risk that involves some uncertainty.
Should I consider buying Rolls-Royce shares?
Rolls-Royce has been one of the top-performing FTSE 100 stocks for 2023. And for good reason – the business is making good progress down the road to recovering from its pandemic difficulties.
When a company’s shares reflects expectations of future growth, there’s always risk. But there are clear reasons for thinking that the Rolls-Royce share price can continue to do well for some time.
