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Can Rolls-Royce shares rise higher through the FTSE 100 as Middle East tensions escalate?


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Rolls-Royce shares have enjoyed an exceptional 2023 on the FTSE 100. Rising geopolitical tensions could see its defence department make further gains.

rolls royceSource: Bloomberg
 

 

 Charles Archer | Financial Writer, London | Publication date: Wednesday 18 October 2023 01:24

Rolls-Royce (LON: RR) shares have enjoyed a stellar year in 2023, rising by 118% year-to-date to 216p. The company was arguably one of the best FTSE 100 stocks to watch this year for a variety of reasons — and CEO Tufan Erginbilgic has, in the eyes of many investors, made huge improvements to what he only recently called a ‘burning platform.’

But for balance, much of Rolls’ improvement is also due to external factors. For example, flying hours have now recovered to close to pre-pandemic levels — and in half-year results, the civil aerospace division accounted for £3.28 billion of total £6.95 billion underlying revenue.

But the second-most important division is the defence department — which generated £1.91 billion — and it could be up for more contracts as defence moves up the political agenda in the wake of Ukraine, Israel, and ever increasing Sino-US tensions.

On this last point, the geopolitics is beyond complex — Putin visited his ‘dear friend’ Xi yesterday while the US simultaneously further limited Nvidia’s ability to sell chips into China. On the other hand, Apple CEO Tim Cook also made a surprise visit to the country yesterday — the leader of the largest capitalistic business in the world in the heart of the communist state.

FTSE 100: Israel-Hamas war updates

Covering the most recent developments, hundreds of people have been killed by a strike on the Al Ahli hospital in Gaza City — Hamas is blaming Israel for the strike while the Israeli military says a rocket barrage fired by Palestinian Islamic Jihad is to blame. In addition, the UN has noted that a school in Gaza was also hit yesterday, killing at least six people.

These latest escalations go beyond the violence of the preceding days because both schools and hospitals are specifically protected under international law except under very specific circumstances. The Israeli military has insisted it’s not targeting civilians but that ‘when we see a Hamas target, we will go after it.’

US President Biden is planning to visit Israel today — and according to Bloomberg sources, is considering a $100 billion funding request to include aid for both Ukraine and Israel. Much of this cash will be used to fund defences and Rolls could well be a beneficiary.

Rolls-Royce shares: where next?

Half-year results were positive — underlying operating profit came in at £673 million with free cash flow of £356 million reflecting ‘continued end-market growth and focus on commercial optimisation and cost efficiencies across the Group.’ Further, the FTSE 100 operator raised its 2023 guidance for underlying operating profit to between £1.2 billion and £1.4 billion, and free cash flow to £900 million to £1 billion — due to transformation efforts accelerating its ‘financial delivery.’

Even the analysts perhaps most bearish on Rolls — JP Morgan — lifted their sell recommendation in August, admitting that ‘we had been very sceptical that Rolls-Royce would be able to raise its prices so significantly, but it appears we were mistaken.’

Then there’s the small nuclear modular reactors to consider — the UK plans to increase its nuclear power capacity to 24 gigawatts by 2050, representing circa 25% of projected electricity demand, almost double the 14% of today. And Rolls-Royce, having already received some funding from the government which owns a golden share in the company, is the only business whose SMR tech is under review by European regulators.

The FTSE 100 company is one of six businesses competing for government contracts — with a winner set to be announced in spring 2024. SMR division CEO Chris Cholerton notes that ‘securing a domestic contract is vitally important to unlock the enormous global export potential of our clean energy technology.’

But it’s worth remembering that Rolls-Royce is still undergoing s cost savings review; yesterday, it announced that it plans to cut another 2,500 roles globally to create a ‘more efficient and effective company.’ For perspective, Rolls already cut 9,000 staff during the pandemic.

Analysts suspect that German operations will be hit hardest, and especially the Power Systems operation. For context, in its results the FTSE 100 titan noted that ‘Power Systems margins were lower but are expected to improve in the second half due to our pricing actions.’

Erginbilgic argues that he is ‘building a Rolls-Royce that is fit for the future…a more streamlined and efficient organisation that will deliver for our customers, partners and shareholders.’ The company plans to communicate its strategic review findings and set medium-term financial targets at its Capital Markets Day on 28 November.

However, airline flying hours are recovering rapidly; Bank of America analysts think they will recover faster than Rolls has predicted. And if the company wins its SMR bid and also gets more defence sector contracts due to the ever increasing geopolitical volatility, these constant cuts could hamstring the future recovery.

But the markets have reacted positively so far.

 

 

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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