Here’s where I think the Rolls-Royce share price is headed next

It’s been a slow start to the year for the Rolls-Royce (LSE: RR) share price. The stock is sitting around the middle of the pack in the FTSE 100 when ranked on year-to-date returns. This means it’s underperforming the FTSE 100 return so far this year. However, over 12 months, the share price is up a much more impressive 19%.

So is the Rolls-Royce share price going to charge ahead from here? Or is it destined to underperform the FTSE 100? Let’s take a closer look.

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The recovery and outlook

Rolls-Royce really suffered during the pandemic as travel restrictions largely put a stop to flying. As such, demand for aircraft engines from the company’s Civil Aerospace division dropped significantly. In fact, in the 12 months to 31 December 2020 (FY20), sales from Civil Aerospace crashed 37% compared to FY19. This was particularly painful for Rolls-Royce as this is by far the company’s biggest business.

Things aren’t looking great for FY21 as it stands either. Revenue for Civil Aerospace is expected to dip again, but by a much smaller 0.9% this time. Having said this, Covid still heavily disrupted travel during 2021. So it’s not too surprising that demand for aircraft engines was still reduced across the year.

If I was to buy the shares today though, I’m more concerned about the company’s future growth. And actually, things are looking up.

For one, Civil Aerospace is expected to grow by an impressive 17.5% in FY22, and make an operating profit for the first time since 2019. Rolls-Royce’s other two big divisions – Defence Aerospace and Power Systems – are expected to grow too. In fact, Defence Aerospace, Rolls-Royce’s military engines business, has been stable throughout the pandemic, unlike Civil Aerospace. To my mind, this adds good diversification to the company’s revenue profile.

City analysts are then expecting significant pre-tax profit growth for FY22 of 97.5%. Also, free cash flow is expected to be positive this year for the first time since before the pandemic.

Where is the Rolls-Royce share price headed?

It does look like Rolls-Royce is turning a corner after a difficult two years. However, it’s important for global air traffic to recover if Civil Aerospace is to grow from here.

According to FitchRatings, the recovery in air traffic will continue this year, but slower than initially expected. It quotes lower business travel, and a slow uptake in international flying, that are both still impacting the industry. This remains a key risk to Rolls-Royce in the year ahead.

The valuation doesn’t look all that compelling at this level either. On a forward price-to-earnings ratio, Rolls-Royce shares are valued on a multiple of 20. This is high, in my view, and would demand high growth rates for me to want to buy the shares.

One other factor to consider is that Rolls-Royce isn’t expected to pay a dividend until at least FY23.

So, for now, I don’t expect the Rolls-Royce share price to increase much from here. If there’s a significant pick-up in air traffic and no further Covid setback, then I can see the share price rising. Then, if Rolls-Royce is able to start paying a dividend sooner than expected, it may be a more attractive investment.

But I won’t be buying the shares in my portfolio just yet.

Dan Appleby has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

This post was originally published on Motley Fool

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