Decarbonization Regulations And Supply Fragmentation Will Squeeze Margins

Key Takeaways

• Structural headwinds in decarbonization, market shifts, and new competition threaten long-term profitability, market share, and earnings visibility for Rolls-Royce.
  
• High pension liabilities, debt levels, and rising supply chain costs may constrain investment, erode margins, and limit recovery in core business segments.
  
• Transformation-driven efficiency gains, strategic market expansion, and investments in technology and SMRs are enhancing profitability, resilience, and long-term growth potential across all divisions.

Catalysts

Develops and delivers mission-critical power systems in the United Kingdom and internationally.

• Rolls-Royce's exposure to ongoing acceleration in decarbonization regulations and the global shift towards net zero means that current profitability in traditional large gas turbine engines is unlikely to be sustainable over the long term, with significant R&D investments required for next-generation powertrains likely to depress margins and slow earnings growth in future years.
  
• The high dependence on the widebody aircraft segment, expected to face a slower and structurally weaker recovery versus narrowbody due to persistent fleet mix changes post-pandemic, implies that revenue growth in Civil Aerospace may plateau as global airline ordering skews away from Rolls-Royce's core large-engine offerings.
  
• Rising supply chain de-globalization and localization pressures threaten to permanently increase operating costs and disrupt manufacturing efficiency, eroding the company's current margin gains and limiting improvement in long-term profitability even as procurement savings programs mature.
  
• Legacy pension liabilities and an elevated debt load, currently manageable with strong near-term cash flow, may increasingly constrain the ability to reinvest for growth or weather shocks, creating structural risks to net margins and free cash flow as secular headwinds intensify.
  
• Fast-advancing alternative propulsion technologies and intensifying competition from new, especially state-backed, entrants risk rapidly obsoleting existing engine architectures and shrinking Rolls-Royce's market share, leading to a potential decline in both revenue visibility and long-term earnings power.

Rolls-Royce Holdings Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Rolls-Royce Holdings compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Rolls-Royce Holdings's revenue will grow by 2.5% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 29.6% today to 8.4% in 3 years time.
• The bearish analysts expect earnings to reach £1.8 billion (and earnings per share of £0.2) by about August 2028, down from £5.8 billion today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 24.9x on those 2028 earnings, up from 15.6x today. This future PE is greater than the current PE for the GB Aerospace & Defense industry at 24.7x.
• Analysts expect the number of shares outstanding to grow by 0.53% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.86%, as per the Simply Wall St company report.

Rolls-Royce Holdings Future Earnings Per Share Growth

Risks

• The company is experiencing sustained improvements in operating profit, free cash flow, and operating margins across all business divisions, driven by a rigorous transformation program and efficiency initiatives, which points toward durable upside in net profit and shareholder value creation over the long term.
  
• Rolls-Royce is successfully capturing strong secular growth in end markets such as civil aerospace (with aftermarket and large engine activity), governmental/defense (with a record order backlog and improved contract profitability), and data center-driven power generation, supporting robust multi-year revenue visibility and stability.
  
• Strategic investments in technology, digitalization, and next-generation engines are already resulting in cost reductions, higher time on wing, improved contract terms, and customer retention, all of which are driving growing long-term services agreement (LTSA) margins and underpinning stronger cash flows for years to come.
  
• The company's SMR (Small Modular Reactor) business has achieved significant commercial milestones with major contracts in the UK and Europe and is expected to be profitable and free cash flow positive by 2030, providing material revenue diversification and a new avenue for long-term growth.
  
• Strengthening of the balance sheet with a growing net cash position, continuing credit rating upgrades, disciplined capital allocation (including capital investments and substantial cash returns to shareholders), and proactive mitigation of supply chain risks, all point to higher resilience and improving net margins, supporting potential further increases in share price.

Valuation

• The assumed bearish price target for Rolls-Royce Holdings is £4.1, which represents two standard deviations below the consensus price target of £10.21. This valuation is based on what can be assumed as the expectations of Rolls-Royce Holdings's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of £14.4, and the most bearish reporting a price target of just £2.4.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be £21.0 billion, earnings will come to £1.8 billion, and it would be trading on a PE ratio of 24.9x, assuming you use a discount rate of 7.9%.
  
• Given the current share price of £10.72, the bearish analyst price target of £4.1 is 161.6% lower.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.