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So, Is It the Airline Results Or The Rolls Royce Ones That Matter?

Beginner

Rolls Royce (LON: RR) shares jumped 25 pence, or near 24% in just the one day last week. Being on the right end of that would have been good – which means we must analyse why it happened, so we have a chance of spotting it being about to happen again. The standard story we’re being told is because the new CEO is a really great guy who knows what he’s doing. Also, the last CEO set the stage for a recovery. Which, you know, they’re not both going to be true because if the last CEO was great then why is there a new one?

Rolls Royce

Which is one interesting lesson, that the stories which are attached to share price movements don’t all have to be true they just have to be agreed. In fact, an awful lot of what we get from the media is a series of just so stories. Prices move, people look for a story about why. That’s just the way humans work, stories matter to us.

What Matters About Investment Stories

What matters to us as investors about this is twofold. In the short term the story is always going to win. So, always pay attention to what looks or sounds like a good story. For that will change the behaviour of other investors and thus the share price.

But in the medium term the truth will out, the best story in the world won’t beat actual numbers. So, we need to look through the story and try to consider underlying numbers. With Rolls Royce this is really about whether the change in management is important, or do we have simply as resurgence in the jet engine business?

Is This About Jet Engines or Airlines?

To test that we can look at the airlines themselves. Easyjet is forecasting a return to substantial profit this year. Ryanair has just reported record third quarter profits. But more importantly, British Airways owner, IAG (LON: IAG) reported a return to profit the same day we saw that RR leap. So, what is it that’s actually going on here?

British Airways

This is the point at which we’ve got to look at a proper economic model of the Rolls Royce business. Yes, we can think of it as a large engineering company, a maker of modular nuclear power plants, power station turbines, all sorts of things. But as an economic unit it’s not even, not really, a seller of jet engines for aircraft. What it really is a seller of servicing for jet engines based upon the hours they spend in the air.

Jet engines

Jet engines are sold to airlines, of course they are, and there’s margin there too. But the real beating heart, in economic terms, for Rolls Royce is charging an airline a maintenance and service fee for each of those engines. That fee dependent upon how many hours that engine spends in the air, actually flying. RR wasn’t, particularly, hit by airlines not buying engines during lockdown. But by airlines not using engines during lockdown. Rolls Royce actually has a control room that tracks each and every large aircraft engine and the time it spends flying. For operational reasons, of course, not merely and solely billing.

The Correct Rolls Royce Economic Model

Now we’ve that economic model we can ponder whether it’s the new CEO or the revival of the income that matters to the share price? IAG is important here because they’re a long-distance airline, in a manner that Easyjet and Ryanair are not. We all knew that long distance would be the last to come back of the varied forms of travel and if that is coming back then that is good for RR. 

OK, so it’s decision time then. This 24% jump in Rolls Royce is all about the wonderful things the new CEO is going to do? That is, structural change? Or it’s about that cyclical change in what we already know is the financial heart of Rolls Royce, hours in the air of its engines?   

So, Which Rolls Royce Story Do We Buy Into?

The importance of this is that it determines what happens next. If it’s all about the new CEO then we need to monitor his plans, see how they work out and so on. Which might well lead to a substantial revaluation of the share price in that medium term. On the other hand, if this is a cyclical return of the old and basic business model then we need to be monitoring that cycle, not the new plans.

Well, obviously, we each have to make our choices about that. But it is still true that the why of the RR share price jump is what gives us the indication of what will happen next.

Editor

Tim Worstall is a freelance journalist who also used to be the world's leading scandium wholesalers (one of the rare earths). His Wikipedia entry gives a flavour.

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