Rolls-Royce Stock Turnaround: How Much Is Priced In?

What did Erginbilgiç find when he took over?

A big brand with thin profits. Erginbilgiç arrived nearly four years ago. Civil Aerospace, the largest division, was earning an operating margin of just 2.5%, as the company's own capital markets day release later admitted. The group margin was about 5% and free cash flow, the cash left after running the business and investing in it, was about £0.5bn. Return on capital, Rolls-Royce's version of return on invested capital, was under 5%.

Make a guess

When Erginbilgiç arrived, what operating margin was Civil Aerospace earning?

Tap your guess

0–5%Your guess5–10%Your guess10–15%Your guess15–25%Your guess

0123456789.0123456789%When he arrived

Spot on.Close, a little low.Close, a little high.Way off, too low.Way off, too high. It was 2.5%.

Just 2.5%. In the latest half-year it was 25.3%, ten times higher.

When he arrived2.5%

Latest half-year25.3%

His fix was blunt. About 2,500 roles went, mostly in middle management. Rolls-Royce brought in zero-based budgeting, which means justifying every cost line from scratch each year. It also renegotiated loss-making service contracts with airlines and pushed procurement savings from suppliers. By the end of last year, the annual results say, the efficiency programme had saved £0.6bn against a £0.5bn target, and third-party procurement savings had reached £1.2bn against a £1.0bn target.

Targets were set, beaten and raised twice

1. Day 1New CEO, shares at 91p"Burning platform" speech to staff
2. Month 11First mid-term targets£2.5–2.8bn operating profit
3. Month 26Targets hit two years earlyDividend back, £1bn buyback
4. Month 38Targets raised again£7–9bn buyback over three years
5. Month 43Guidance lifted£4.7–4.9bn this year; A3 and A- ratings

How did Rolls-Royce beat its own targets so fast?

Nearly three years ago, Rolls-Royce promised to roughly quadruple operating profit to £2.5bn–£2.8bn, with a 13–15% margin and £2.8bn–£3.1bn of free cash flow. Early last year it said it would hit those numbers two years early, and set new ones. Earlier this year it raised them again.

Every mid-term target has been raised twice

Mid-term target	First set	Raised once	Now
Operating profit	£2.5–2.8bn	£3.6–3.9bn	£4.9–5.2bn
Operating margin	13–15%	15–17%	18–20%
Free cash flow	£2.8–3.1bn	£4.2–4.5bn	£5.0–5.3bn
Return on capital	16–18%	18–21%	23–26%

The delivery has been steady. Underlying operating profit went from £1,590m in his first full year to £2,464m, then £3,462m last year at a 17.3% margin. Free cash flow went from £1,285m to £2,425m to £3,270m. In the latest half-year, profit rose 46% to £2,534m, a 22.5% margin, and free cash flow was £1,964m.

Profit and cash have climbed every year since the reset

012345£6bnBeforeYr 1Yr 2Last yrThis yrTargetGuidance £4.7–4.9bn£5.1bnOperating profit£5.2bnFree cash flowBefore£0.7bn£0.5bnYr 1£1.6bn£1.3bnYr 2£2.5bn£2.4bnLast yr£3.5bn£3.3bnThis yr£4.8bn£3.9bnTarget£5.1bn£5.2bn

Notice the odd thing in that chart. This year's profit guidance of £4.7bn–£4.9bn is already within touching distance of the £4.9bn–£5.2bn mid-term target, which is set for two years from now. Either the target is conservative, which has been the pattern, or some of this year's profit won't repeat. The answer sits in how Rolls-Royce's service contracts work.

How does Rolls-Royce make money from engine flying hours?

Rolls-Royce builds engines for widebody jets such as the Airbus A350 and Boeing 787, and for business jets. It often sells new engines at a loss and earns its money over the decades the engine flies. Most of that comes through long-term service agreements (LTSAs), often called "power by the hour". The airline pays a rate for every engine flying hour (EFH). In return, Rolls-Royce maintains and overhauls the engine whenever it needs it.

Airlines pay as they fly; Rolls-Royce books revenue as it does the work

1. Airline flies the engine (Pays a rate per flying hour) to Cash arrives
2. Cash arrives to LTSA balance (Money owed back as future maintenance)
3. LTSA balance (Money owed back as future maintenance) to Shop visits (Revenue and profit booked as work is done)

The timing matters. Cash arrives as hours are flown: £3.4bn of invoiced flying-hour receipts in the latest half. Revenue is mostly booked later, when engines come in for shop visits (overhauls). The gap sits on the balance sheet as a liability, the LTSA balance, which stood at £10.4bn. While a fleet is young and flying more, cash in runs ahead of work done. That growth in the balance is free cash flow that hasn't yet shown up as profit. Last year it added £572m. The mid-term plan assumes £0.8bn–£1.2bn a year, driven by flying hours rising to 130–140% of pre-pandemic levels, a higher hourly rate and fewer shop visits per hour as durability improves.

It also works the other way. When engines wear out faster than planned, Rolls-Royce does more shop visits for the same fixed hourly price, and contracts can turn onerous, meaning loss-making over their life. Rolls-Royce then has to book a provision, an up-front charge for the expected loss. That was a large part of the mess Erginbilgiç inherited.

Why did LTSA cash growth slow?

In the latest half-year, the net LTSA balance grew by only £86m, against £472m a year earlier. Large-engine flying hours still rose 4%, to 113% of pre-pandemic levels. Can you spot what changed?

Find the cause

Flying hours rose, yet LTSA balance growth fell from £472m to £86m. Which line explains it?

Rolls-Royce Civil Aerospace, latest half-year

Large-engine flying hours rose 4% The hourly rate airlines pay improved More shop visits, including many more refurbishments, plus higher LTSA margins and catch-ups The large-engine order book reached 2,266 engines

Tap the phrase you think is the tell.

Spotted it.Not that phrase. Major large-engine shop visits rose to 294 from 217. Revenue caught up with cash, which is healthy, but it means less free cash flow from the balance.

• “Large-engine flying hours rose 4%” More hours means more cash in. This pushes the other way.
• “The hourly rate airlines pay improved” Also more cash in, not less.
• “More shop visits, including many more refurbishments, plus higher LTSA margins and catch-ups” Right. More work done and higher booked margins move money out of the balance and into revenue.
• “The large-engine order book reached 2,266 engines” Orders are future business. They don't move this half's balance.

Explain every phraseHide the other explanations

The second half of that answer matters most. When Rolls-Royce lowers the expected lifetime cost of a contract, through better durability or better prices, it books a catch-up: extra revenue now for hours already flown. In the latest half, net contractual and operational improvements added £497m to profit, made up of £372m of contract catch-ups and £125m of releases of onerous-contract provisions. That is about a fifth of the half's operating profit.

About a fifth of first-half profit came from contract improvements

Underlying operating profit£2.53bn

• 20%£0.50bnCatch-ups and provision releases
• 81%£2.04bnEverything else

These gains are real economics. Better contracts are worth more. But they are partly one-off: they bring forward several years of improvement into one period. Management expects a smaller contribution in the second half, and a "reduced contribution" by the mid-term. That is the main reason this year's profit nearly matches the target for two years out.

How strong is the civil aerospace recovery?

Demand is not the problem. Rolls-Royce delivered 279 new engines in the half, 18% more than a year earlier. It took orders for 254 large engines, including 40 Trent XWB-97s for Atlas Air's A350 freighters and engines for Delta and SAS, and its large-engine order book reached 2,266. Large-engine overhaul output rose 13%, and the company says it has "effectively eliminated" aircraft grounded waiting for its engines.

Flying hours are the variable to watch. Rolls-Royce now expects large-engine hours at the lower end of its 115–120% of pre-pandemic range this year, even as it raised profit guidance despite the conflict in the Middle East. Its mid-term plan assumes 130–140%.

Every division is already beyond its mid-term margin target

2 yrs agoLast yrLatest halfTarget midpoint

51015202530%0

16.6%20.5%25.3%22.0%

Civil2 yrs ago16.6%Last yr20.5%Latest half25.3%Target midpoint22.0%

14.2%14.4%21.0%15.0%

Defence2 yrs ago14.2%Last yr14.4%Latest half21.0%Target midpoint15.0%

13.1%17.4%20.3%19.0%

Power Systems2 yrs ago13.1%Last yr17.4%Latest half20.3%Target midpoint19.0%

CivilDefencePower Systems

Is the Trent XWB-97 durability problem fixed?

Not yet. The XWB-97 is the bigger, hotter-running version of the A350 engine, and the A350-1000's only engine option. In hot, sandy Gulf conditions its turbine blades wear faster than expected. Emirates' Tim Clark said nearly three years ago that it needed to stay on wing for 2,000–2,500 cycles (a cycle is one take-off and landing) before he would order the plane. Two years ago Erginbilgiç promised to double the engine's time on wing in harsh environments within two to three years.

Elsewhere the fixes are further along. On the Trent 1000 (Boeing 787), almost half the TEN fleet now has improved turbine blades, and the upgraded Trent 1000 XE has won three airlines, including LATAM. The XWB-84, the A350-900 engine, should have its remaining part-life extensions certified by the end of this year. Fewer overhauls per flying hour is the whole game: the mid-term plan has total shop visits falling to 1,300–1,400, from 1,480–1,550 this year, even as hours grow.

What do Defence and Power Systems add?

Defence is the steady one. Revenue rose 17% in the half to £2,484m, and the order backlog of £17.5bn covers more than three years of sales. Rolls-Royce powers the B-52 re-engining (F130), the US Army's MV-75 tiltrotor, nuclear submarines for the UK and AUKUS, and the engine for GCAP, the fighter being developed by the UK, Italy and Japan. The UK has pledged £8.6bn to GCAP by the end of the decade. Its 21.0% half-year margin was helped by aftermarket work and international sales. The target is still 14–16%, so expect some fade. For the wider sector, see our piece on BAE Systems and UK defence stocks.

Power Systems is the surprise. It sells mtu engines and generators, and data centres need backup power when the grid fails. Increasingly, while they wait for a grid connection, they need prime power, gas engines that run all the time. Power-generation revenue grew 41% in the half, orders rose more than 50% to £4.6bn, and orders cover about 100% of this year's new-equipment sales and more than half of next year's. Rolls-Royce now expects power-generation equipment revenue to grow 25% a year to the end of the decade, and governmental (military) equipment revenue 20%.

What are Rolls-Royce SMRs worth?

Small modular reactors (SMRs) are factory-built nuclear plants. Rolls-Royce SMR was chosen as the sole technology for the UK's programme, with three units planned at Wylfa on Anglesey. ČEZ, the Czech utility, has invested in the business and committed to up to six units. In Sweden, Videberg Kraft has selected it to supply three. The UK and Czech contracts are now generating revenue, and Rolls-Royce expects the business to be profitable and free-cash-flow positive by the end of the decade. It is not in the mid-term targets, so it is an option on top. It's also a long-dated one, with the cost overruns that nuclear projects are known for.

How much is Rolls-Royce returning to shareholders?

A lot, and the balance sheet allows it. Net debt was £1,952m at the end of his first year. Rolls-Royce now has £2,136m of net cash and £9.0bn of liquidity. Moody's and Fitch recently upgraded it to A3 and A- respectively, both solidly investment grade, and S&P moved its BBB+ rating to a positive outlook.

The dividend returned last year after more than five years, at 9.5p for the year, with a 6.0p interim declared this year. That is still under 1% of the share price, so the dividend yield is not the point. Buybacks are. After £1bn last year, Rolls-Royce plans £7bn–£9bn over three years, including £2.5bn this year. That is about 6–8% of today's market value, while the share count has already fallen 0.7% over the past year.

The returns are paid for by better use of capital, not by borrowing. Return on capital, which Rolls-Royce defines as operating profit after tax as a percentage of the average capital tied up in the business, was 22.0% over the latest twelve months, up from 18.9% last year and 13.8% the year before. The mid-term target is 23–26%. A business earning that on its capital can grow and still hand most of its cash back.

Is Rolls-Royce stock expensive compared with GE Aerospace and Safran?

Not by sector standards. GE Aerospace, which leads in narrowbody engines through its CFM partnership with Safran, is worth $315bn, about twice Rolls-Royce. Safran, the French engine and equipment group, is worth €132.4bn. On price-to-earnings, Rolls-Royce's 30 times forward earnings sits between the two.

Rolls-Royce is priced like Safran, cheaper than GE

	Rolls-Royce	GE Aerospace	Safran
Market value	£116.6bn	$315.0bn	€132.4bn
Trailing P/E	38.8x	35.8x	34.3x
Forward P/E	30.0x	35.9x	27.3x
EV / free cash flow	25.7x	38.8x	25.1x
Share price, past year	+⁠21.7%	+⁠1.8%	+⁠7.2%

Measure Rolls-Royce against its own guidance instead. This year's free cash flow midpoint of £3.9bn is a 3.3% yield on the £116.55bn market capitalisation. The £5.15bn midpoint of the mid-term target is a 4.4% yield. Enterprise value (market value minus net cash) is £114.47bn, or about 24 times this year's operating profit midpoint. Those are the multiples of a high-quality compounder, not a recovery stock.

Hitting the target only justifies today's price at about 23 times cash

Pick free cash flow two years from now and the multiple investors pay for it

Free cash flow

£4.5bn£5.15bn£6.0bn

Price / free cash flow

20x25x30x

Implied market value£90bn£113bn£135bn£103bn£129bn£155bn£120bn£150bn£180bn

−23.1%−3.4%+15.4%−12.0%+10.3%+32.5%+2.6%+28.2%+53.8%below Todaybelow Todayabove Todaybelow Todayabove Todayabove Todayabove Todayabove Todayabove Today

Today £117bn

£90bn£180bn

The arithmetic is plain. Hit the target and keep a 25 times multiple and the company is worth about £129bn in two years, about 11% more than today, plus buybacks and a small dividend. Put the other way, today's price is about 23 times the target's free cash flow. That is a decent return, not a spectacular one. To get spectacular, Rolls-Royce has to beat its targets again, which it has done twice, or convince the market that growth continues well past them.

What could go wrong?

• Catch-ups fade. About a fifth of first-half profit came from contract improvements, and management expects less. Underlying growth has to replace it.
• Durability. If the XWB-97 fixes underdeliver in the Gulf, shop visits and LTSA costs rise.
• Flying hours. Conflict in the Middle East already pushed guidance to the low end. A recession that grounded widebody fleets would hit cash first.
• Supply chain. Parts shortages cost £150m–£200m of cash this year and added £77m of charges in the half.
• Currency. Rolls-Royce earns largely in dollars. Its $22bn hedge book smooths this, and its targets assume $1.33 to the pound.
• Data-centre cycle. Power Systems' best growth depends on AI spending holding up.

Our read

The turnaround is real. Margins went from about 5% to 22.5% in the latest half, debt became net cash, and the targets were beaten twice. A good share of that is better management, not just a traffic recovery: repriced contracts, lower costs and more durable engines.

The rating has done its job too. At 15 times the share price Erginbilgiç inherited, 30 times forward earnings and a 3.3% free-cash-flow yield, the market already prices in the mid-term targets being hit. The shares rose 21.7% over the past year, faster than GE Aerospace and Safran.

What isn't priced in is the long tail: more years of LTSA balance growth as a young widebody fleet ages, Power Systems riding data-centre demand, and SMRs turning profitable. What could hurt is a run of slowing catch-ups, a Gulf durability setback or a fall in flying hours, any of which would expose a premium multiple.

We'd hold rather than chase. The buyback of 6–8% of the company over three years gives steady support, but new money is buying a great business at a full price. A pullback toward 20–25 times free cash flow would make the next leg much easier to underwrite.

Go deeper

• Revenue recognition: why Rolls-Royce's cash and profit come at different times, and how catch-ups move earnings.
• Reverse DCF: work out what growth a 30 times multiple already assumes, as we did above.
• Dilution and buybacks: how a £7bn–£9bn buyback changes value per share.

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