For shareholders in aeronautical engineer Rolls-Royce (LSE: RR), part of the appeal used to be the dividend.
The shareholder payout was axed during the pandemic and has not come back. But some comments in the company’s latest shareholder report have made me think things might change in the next several years.
Change in tone
I have previously explained why I was not hopeful about the short-term prospects for a restoration of the Rolls-Royce dividend. Despite improving business trends, rising free cash flow and ambitious financial targets, company management was not even mentioning publicly the prospect of bringing back the dividend.
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Since then though, that has changed.
In its annual report published in February, the company identified “a commitment to reinstating and growing shareholder returns” as one of “three clear priorities” in its capital framework.
It explained in more detail: ”When the Board is confident that the strength of the balance sheet is assured and we are comfortably within an investment grade profile, we are committed to reinstating and growing shareholder distributions”.
What does that mean? Basically, the Rolls-Royce dividend looks set to return – and grow – but only once the balance sheet is strong enough.
Balance sheet strength
A strong balance sheet makes sense for any business – and this has been proven at Rolls in recent years. When civil air travel demand collapsed during the pandemic, so did engine sales and servicing orders. That was a disaster for free cash flows at Rolls. They nose-dived from £873m in 2019 to negative £4.1bn the following year.
A sudden collapse in demand for civil aviation remains a risks, whether the reason is a pandemic, terrorist attack, volcanic dust, or some other event. That brings a risk of Rolls again heavily diluting existing shareholders, as it did during the pandemic.
Strengthening the balance sheet helps reduce that risk – but ties up cash that could otherwise fund the Rolls-Royce dividend.
The firm ended last year with £2bn in net debt. That was a sharp improvement from the prior year. But I see it as a long way from having a balance sheet with assured strength.
Future dividend prospects
On that basis I think there remains work to be done before the Rolls-Royce dividend comes back. I would be surprised to see it make a return this year, for example.
Longer term though, I do expect it to make a return as long as business results remain strong. Although the timeline is uncertain, management has now clearly set an expectation for the payout to make a comeback at some point.
That is not guaranteed, as is always the case with any dividend. But if the business continues to perform well financially, I now think the Rolls-Royce dividend could return over the next few years.
On its own though, that is not enough for me to buy the shares. After all, the risk of a sudden collapse in demand remains.
After rising 180% in the past year, I do not think the Rolls-Royce share price offers me a comfortable margin of safety. So, dividend or not, I have no plans to buy.
