Frenzy is probably an overused word in journalism but I think it applies to the recent Rolls-Royce (LSE: RR) share price performance.
The stock’s up a staggering 408% over two years and 195% over 12 months. It’s the only FTSE 100 company to hold its own against the Magnificent Seven mega-cap US tech giants.
Many investors will view a blistering-momentum stock like this one as a brilliant opportunity to bank a rapid gain. I see it as a threat.
I like cheap stocks
I prefer to buy shares when they’re down in the dumps, which is why I’ve just bought beaten-down Burberry. I’m willing to give the luxury fashion house time to recover from its current travails.
That’s a risky move. So is buying Rolls-Royce, but in a different way. While investors hate Burberry they love Rolls. Some of the share price growth is froth as speculators pile in. It’s inevitable. Yet now the frenzy’s easing. The stock’s up another 4.84% over the last month, but trailed the FTSE 100’s 7.65% surge.
This gives me a bit of breathing space to work out whether it’s still worth buying at today’s heady levels.
I actually called the Rolls-Royce recovery correctly, buying in October 2022 after deciding it had been oversold. The problem is I didn’t buy enough. Also, I didn’t bank on the impact of new boss Tufan Erginbilgiç, who took over three months later. Nobody did. His hard-man act initially scared a lot of investors, before winning them over in spades.
Spare a thought for predecessor Warren East, who inherited a bribery scandal and battled through the pandemic. Covid grounded global fleets and smashed the vital revenues Rolls-Royce generates from aircraft engine maintenance contracts, which are based on miles flown. Erginbilgiç landed just as flying took off again.
Still, Napoleon liked a lucky general, and so do I. In February, ‘Turbo Tufan’ delivered record free cash flow of £1.3bn and more than doubled the return on capital to 11.3%. Its Power Systems and Defence divisions are also flying, not just Civil Aerospace.
This stock’s pricey now
He deserves the credit for overhauling the group’s inefficient structures and changing its mentality. But he didn’t end the pandemic or drive up the US dollar, both of which boosted revenues. Nor is he behind the geopolitical problems that have turbo-charged defence stocks. Rolls-Royce also makes turbines for fighter jets and warships, and nuclear reactors for UK submarines.
There is a danger Erginbilgiç’s good run runs out. It tends to do that, as even Napoleon discovered. His abrasive style has played poorly with customers Emirates and Thai Airways. The group’s nuclear small modular reactors risk being sunk by UK government and planning delays.
Rolls-Royce is targeting profits of £2.5bn-£2.8bn by 2027, up from £1.59bn in 2023. It wants operating margins of 13-15%, up from 10.3%. Any undershoot will be punished.
Inevitably, Rolls-Royce shares look expensive after their dramatic run, trading at 30 times forward earnings. The dividend may soon return after four years but markets forecast a meagre 0.63% yield in 2024, rising to 1.06% in 2024.
I really want to buy the shares, but after Erginbilgiç’s luck runs out. As with Burberry, I may have to be patient.
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Harvey Jones has positions in Burberry Group Plc. The Motley Fool UK has recommended Burberry Group Plc and Rolls-Royce Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
