It survived the pandemic, but will Rolls-Royce ever be the same again?

Over the past 15 years, Rolls-Royce (LSE: RR) has lurched from disaster to disaster and shareholders have had to bear the pain. The stock has produced an awful total return (ie including dividends) of -1.2% per year over the past decade-and-a-half, compared to 5.4% for the FTSE All Share.

In some ways, this performance is surprising. Rolls is one of just two organisations that essentially control the global market for narrow-body aircraft engines. It also designs, produces and maintains the nuclear technology in the Royal Navy's submarine fleet.

These are not markets where customers are willing to sacrifice quality for price. If an airline owns a plane with Rolls-Royce engines, it will not skimp on service and maintenance spending. That practically guarantees a recurring income from annual servicing and parts. Moreover, it can take a decade or more to design and test a new engine – most other companies just do not have the time nor the money to pursue this.

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There are also plenty of reasons why the Royal Navy is unlikely to shift its nuclear contract to a different supplier – and the navy isn't the company's only major defence customer. It recently signed a 30-year, $2.6bn contract with the US Air Force to replace engines for its B52 planes.

So in theory, Rolls essentially dominates two specialist markets where it seems unlikely the firm is going to face much in the way of competition any time soon. However, even with these competitive advantages, it has still struggled to create value for shareholders.

Why has Rolls-Royce struggled despite its competitive advantages?

Virtually all of the company's current issues are a direct result of the coronavirus pandemic.

Rolls has four main markets. In order of size these are civil aerospace (£4.5bn in revenues in 2021), defence (£3.4bn), power systems (£2.8bn) and so-called new markets (£2m).

Two of these four businesses are highly profitable. Defence generated underlying operating profits of £457m last year and power systems earned £242m.

The other two arms lost a combined £240m. Civil aerospace, the largest division by revenue, reported the biggest loss of £172m.

The civil aviation arm is a fascinating business. The bulk of its revenues are tied to the sale of aircraft engines. Over the past few decades Rolls has installed 15,400 engines on planes of all shapes and sizes. However, the group does not make money from the sale of equipment (in 2019 and 2021 it made a small loss). The real money is made after the sale.

Rolls-Royce does not break out exactly how much it makes from each service contract, but to give you some idea of the potential profits, the operating margin at the civil aviation business in 2019 was 1%. That is, income from service contracts offset all operating costs, research and development costs, the cost of selling engines at a small loss and other expenses (mainly joint ventures). Even without the full picture this makes it clear that the business is highly lucrative.

Unfortunately, during the past two years this lucrative revenue stream has fallen off a cliff. Engines require servicing after a number of hours in the sky. So if planes aren't flying there's no need to service the engines. As a result, service revenue dropped by 41% between 2019 and 2021 and the operating margin dropped to -4%.

The company's past performance is no guarantee of future potential

While the enterprise has a competitive advantage in the civil aviation market, it's still at the mercy of industry trends. And if sales drop suddenly, Rolls-Royce can't cut spending to match. It takes as long as 16 years to train an aerospace engineer so the firm needs to hang on to its skilled workers.

Before the pandemic, the company was on the way to a healthy cash flow yield, but survival quickly became the name of the game in 2020. Management is confident that the business can return to form this year. It is targeting an operating margin in the high single digits and expects trading cash flow to exceed operating profit.

These targets are promising, but I'm worried that the pandemic has done irreparable harm to Rolls-Royce. During the past two years it has cut more than 9,000 jobs, mostly skilled engineers, which will be hard to replace.

It also sold its ITP Aero business to raise £1.4bn. ITP – which is responsible for the maintenance of the Spanish Armed Forces' engines – was one of the corporation's valued defence assets.

On top of this, group net debt ballooned from £1.3bn in 2019 to £5.2bn at the end of 2021 and the number of shares in issue (following a cash call in 2020) has jumped from 5.5bn to 8.4 billion.

Overall, Rolls-Royce is a smaller, more leveraged entity than in 2019. Until management can prove it is back on a sustainable footing, it's very hard for me to put a value on the enterprise.

While the company might be one of the UK's most storied engineering groups, it's not necessarily a great investment. Without concrete earnings and cash flow figures, I'd stay away from the shares.