Where next for the Rolls-Royce share price?

Will the Rolls-Royce (LSE:RR) share price go higher or lower? I find making a bull and bear case helps me decide whether to add a stock to my investment portfolio.

The bull case for Rolls-Royce

Rolls-Royce secured grant funding of £220m from the UK Research and Innovation fund for its small modular nuclear reactor (SMR) project this November. SMR plants are smaller than conventional nuclear plants, which opens up more sites for deployment. SMR systems and parts can be assembled through a standardised process in factories and shipped for installation. An SMR plant is expected to cost around £2bn, roughly one-tenth the cost of a conventional plant like Hinkley Point C, but the power output is lower.

Between seven and nine GWe of power from SMR plants are expected to be deployed in the UK and internationally between 2030 and 2050. That’s roughly 48 plants using an average of 330 MW per plant. For £2bn per plant, that’s £96bn of revenue over 20 years, but let’s say £4.8bn per year on average, of which Rolls-Royce should get 80%. A £3.8bn annual sales boost is around 25% of Rolls-Royce’s peak 2015 sales and would add significant diversification to the company’s revenue mix.

There are more reasons to be cheerful about the prospects for the Rolls-Royce share price. Although the company is still making provisions for the Trent 1000 engine fixes, the problem has been solved. Rolls-Royce Pearl 700 engines will power Gulfstream’s ultra-long-range corporate jets, and the company signed a $2.6bn contract to supply F-130 engines to the USAF. Perhaps most importantly, Rolls-Royce has made it through the worst of the pandemic. International travel is picking up again. This is vital to Rolls-Royce as it typically makes its money from servicing engines rather than their sale.

Rolls-Royce share price bear case

Rolls-Royce has asked for clearance to begin the four- to five-year long approval process of seeking regulatory approval from the Office for Nuclear regulation for its SMR. Thus, SMR revenues are conditional on approval and years away. International travel did open up, but restrictions will keep the volume below pre-pandemic levels for years to come, and coronavirus cases are spiking again. Besides, Rolls-Royce is heavily exposed to the slower-to-recover long-haul wide-body jet market. Rolls-Royce is getting on trend with new engines for narrow-body aircraft, but these are years away.

Rolls-Royce saw its share price crushed as it raised massive amounts of equity and debt during the pandemic. The company recently sold $2bn worth of businesses to shore up its balance sheet, possibly at firesale prices. Roll-Royce has seen its gross margin contract from 23% to (2)% over the last seven years. The same is true for its operating margins excluding unusual items, which fell from 10% to (22)% over the same period.

Table 1. Rolls-Royce has seen its margins decline over the last seven years 

The pandemic might have crushed margins recently but cannot be blamed for the multiyear contraction. If those SMRs are assembled on wafer-thin margins, how much revenue will flow to the bottom line?

I’m a Rolls-Royce bull

I am under no illusions that for the Rolls-Royce share price to move significantly higher, many things have to go in the company’s favour. But, I think a lot of the bad news is already in the stock price. The potential is there, but Rolls-Royce needs to deliver, and I believe they will, but it will take time. I am happy to own Rolls-Royce for the long term in my Stocks and Shares ISA.

James J. McCombie owns shares in Rolls-Royce. 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.