Rolls-Royce (LSE:RR) shares looked like they were heading for 500p last month. For context, two years ago the share price was around 60p.
But now, the share price is closer to 400p. What’s happening?
Issues at Airbus
Airbus is one of Rolls-Royce’s biggest partners and clients, with the UK-built engines being used on wide-body jets made by the European multinational.
However, in late June, Airbus cut its delivery target for the year to 770 aircraft, down from 800. The implication is that fewer Rolls-Royce engines will be going on Airbus aircraft this year and that compounds issues at Boeing.
Airbus has since raised its guidance for the next two decades — led by wide-body jets. However, near-term issues appear to have put downward pressure on Rolls-Royce stock.
Rotation out of booming sectors
Recent market trends show a rotation out of the booming tech sector. While Rolls-Royce isn’t a tech company, it trades at very high near-term multiples, suggesting a potential correlation. As investors move away from tech, Rolls-Royce has also seen fluctuations, indicating that high-multiple stocks across various sectors might be experiencing similar pressures.
Like the booming tech and artificial intelligence sector, Rolls-Royce’s near-term valuation has scared some investors. It’s currently trading at 27.6 times forward earnings, which puts it at a large premium to the FTSE 100, and to some of the stocks in the sectors in which it operates — civil aerospace, defence, and power systems.
And like the booming tech sector, Rolls-Royce is expensive because of its growth forecast. However, major events, such as the return of Trump to the White House, could alter these expectations.
Priced for perfection
On the topic of a Trump presidency, which is now priced at 70%, his return to the White House could have a profound impact on defence spending, and defence is 25% of Rolls-Royce’s business.
There are several ways to assess the impact of a Trump presidency on defence spending. Firstly, he wants to spend more on things like missile defence in the US — that won’t benefit Rolls — and also make European partners spend more on defence.
However, Rolls benefits from commitments to long-term programmes like AUKUS — for which it delivers nuclear propulsion — and Tempest — where it makes jet engines. More tanks, guns, and munition spending means nothing to the British engineering giant. One concern is that Trump could pull the US out of AUKUS, although recent indications suggests he wouldn’t.
Likewise, analysts suggest that inflationary Trump policies could halt interest rate cuts. In turn, this could mean less discretionary spending, less travel demand, and fewer flying hours for Rolls-Royce engines.
There’s a heap of possible positive and negative catalysts. And, with some analysts claiming the stock is priced for perfection, it could be an issue.
Going up or down?
There might be some near-term hurdles, but I believe 500p is more likely than 400p. The all-important price-to-earnings growth (PEG) ratio currently sits around 0.99 — very healthy — and my discounted cash flow calculation suggests fair value is around 850p.
This post was originally published on Motley Fool
