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Rolls Royce (LSE:RR) recently rose above 500p following the engine maker's first-half results. This record high has some investors concerned that FTSE 100 Index The high flyer has gotten ahead of himself.
This may be true in the short term, as shares are trading at around 30 times forward earnings. But that didn't stop me from buying more shares in my ISA recently at 477p. Here are four reasons why I did so.
Running at full speed
Firstly, I was very impressed with the company’s first half results. It was hard not to be. Revenues rose 19% year-on-year to £8.2bn, with growth across all three main divisions. Operating profit rose 74% to £1.1bn, with margins up 4.4% to 14%. Free cash flow tripled to £1.2bn.
Meanwhile, net debt has been reduced to £822m, the lowest in more than five years. This has been recognised by credit rating agencies, with two out of three rating the company as investment grade.
Looking ahead, the company expects underlying operating profit in 2024 of between £2.1bn and £2.3bn, up from its previous guidance of between £1.7bn and £2.0bn. It also expects free cash flow of between £2.1bn and £2.2bn, up from £1.7bn and £1.9bn.
The dividend is back
Secondly, the dividend has been reinstated after more than five years. The company will start by paying out 30% of underlying net tax profits before a continuing payout rate of 30-40% each year.
Admittedly, the expected dividend yield for 2025 is paltry at just 1.2%, but I expect the payout to grow significantly over time given the incredible improvement in free cash flow.
In retrospect, this return is symbolic given the financial crisis Rolls faced during the pandemic. The rapid turnaround under Tufan Erginbilgiç has been astonishing.
Higher target price
The consensus analyst target price is currently 542p, which is still 8.8% higher than the current level.
Of course, this target price is not guaranteed and there are risks. One of them is that several international airlines are suspending flights as tensions in the Middle East escalate. If the conflict escalates, this could lead to reduced demand for new aircraft and engines. Serious supply chain problems also persist across the industry.
The future looks bright
However, in the long term, the investment still looks solid to me. The number of aircraft is expected to double over the next 20 years, according to Boeing and AirbusThis will be driven primarily by China and India, where Rolls-Royce is positioning itself to take advantage of the significant opportunities arising from this growth.
Then there are small modular reactors (SMRs), those miniature versions of a nuclear power plant. They are no longer the stuff of science fiction. The UK government could soon be awarding a contract and Rolls-Royce could be at the head of the queue.
Sweden and the Czech Republic have been doing due diligence on Rolls’ SMR technology and I’m sure they won’t be the last. After all, the decarbonisation deadlines enshrined in law are getting closer.
It is understandable that this potential is not reflected in the share price today, but I am investing here with a minimum five-year horizon, so I hope it will be reflected one day.
Each SMR will cost between £2bn and £2.5bn, so this could be a truly huge growth market for Rolls-Royce in the early 2030s.
