The Week Ahead (24-28 Feb): Rolls Royce, Nvidia, China

This week, European equities continued their strong start to the year, outpacing their US counterparts for the first time in over a decade. The STOXX 600 notched further record highs mid-week, fueled by strong performances across banking, energy, and defence stocks.

In particular, Europe’s defence sector has surged on expectations of increased military spending, with names like BAE Systems (LON:BA.) and Rheinmetall AG (ETR:RHM) posting double-digit gains before retreating slightly. It seems that investors, who have long been sceptical of the continent’s growth prospects, are beginning to recognise the relative value on offer compared to a seemingly stretched US market.

Across the Atlantic, Meta Platforms (NSQ:META) has been the clear leader of the Magnificent Seven this year, with its shares up nearly 16%. Apple and Tesla have struggled, though, with some initial cracks starting to appear. All eyes will now be on NVIDIA (NSQ:NVDA), the last to report, as it prepares to release its full-year results on Wednesday.

After an extended period of U.S. stock market dominance, we may be seeing some early signs of capital being rotated elsewhere - whether into European equities, Japanese stocks, or, more controversially, Chinese markets.

China’s stock market has been on a tear after a tough few years. The Hang Seng is up nearly 20% year-to-date, with heavyweights like Alibaba Holding (NYQ:BABA), PDD Holdings (NSQ:PDD), and BYD Co (PNK:BYDDY)  leading the charge. Alibaba has been at the forefront of China’s stock market resurgence, surging 70% year to date and outpacing many of its peers.

Temu owner, Pinduoduo, has also leveraged its cost-conscious appeal to expand market share and BYD continues to dominate the EV space. Even Baidu (NSQ:BIDU), often overshadowed in the AI race, has gained renewed attention.

For the brave, China offers undeniable value. The region remains very cheap relative to its long-term potential (forecast P/E of 11.5 for the Hang Seng), but structural risks persist.

Geopolitical tensions, unpredictable regulation, and ongoing (deflationary) economic challenges mean investors must tread carefully. I’ve personally dabbled in Alibaba shares over the years, seeing potential in its entrenched e-commerce dominance and cloud computing ambitions. But even here, plenty of patience is required—regulatory uncertainty and a perceived lack of visibility into what’s actually going on make Chinese equities a notoriously volatile bet.

It would be interesting to hear any thoughts in the comments on investing in China, or any emerging markets that you think are worth considering. With Europe making a strong case, and China presenting an intriguing risk-reward profile, 2025 could be shaping up to be an inflection point for global investors.

In the UK, a wave of full-year results is set to roll in next week, spanning a wide range of sectors. Industrials like Rolls-Royce, IAG, IMI, and Morgan Sindall will report, as will financial heavyweights such as the London Stock Exchange, Aviva, and St. James’s Place. Healthcare names like Haleon and Hikma Pharmaceuticals will also shed some light on their performances in 2024.

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Economic Calendar

Companies Reporting

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Rolls-Royce: FY 2024 Results

Few stocks in the FTSE 100 have managed to turn things around quite like Rolls Royce. The engineering giant, once synonymous with high-quality aerospace technology, found itself on the ropes during the pandemic. But a combination of post-pandemic tailwinds, aggressive restructuring by an excellent management team, and robust free cash flow generation has seen the share price more than quintuple within two years.

Rolls Royce has even accelerated its progress over the past 12 months, making it a standout performer among UK large caps and delivering gains more reminiscent of high-flying US stocks. The company managed to outpace the FTSE All-Share by a staggering 72% over the past year, highlighting its strong momentum characteristics.

With full-year results for FY24 set to be released on 27 February, investor expectations are high. The company’s turnaround story has been remarkable, but its valuation has also soared to new heights. The question remains: is there still upside left, or has the market already priced in the good news?

Cash Flow Transformation

The biggest shift in Rolls Royce’s investment case has been its cash flow generation. Long-term service agreements (LTSAs) have been somewhat of a game changer for the company. These contractual arrangements between Rolls Royce and airline operators mean that they pay for engine maintenance based on usage rather than making large upfront payments for individual repairs.

These agreements have facilitated a steadier stream of revenues based on flight hours logged by Rolls Royce’s engines, thereby creating much more predictable cash flows for the business. It’s important to remember that Rolls Royce makes quite little from selling these engines themselves, so the LTSAs have been crucial to transforming profitability. The recovery in air travel and increased large engine flying hours have already reached 102% of 2019 levels by Q3 2024.

Reducing the dependence on new engine sales and creating a strong recurring revenue base have made Rolls Royce a different beast altogether. With a growing installed base of widebody engines—critical for long-haul travel—Rolls Royce benefits from an expanding aftermarket business, where high-margin servicing drives better returns. The additional benefit is that as a fleet ages, more engines will enter a higher maintenance phase, providing a further boost to cash flows.

These contracts have been excellent at turning past engine sales into future profits. Free cash flow is now expected to land at the upper end of the £2.1bn–£2.2bn guidance range for 2024, a stark contrast to the cash burn seen in previous years.

Source: Rolls Royce H1 2024 Results Presentation

Profitability on the Rise

Underlying operating profit is set to come in at £2.1bn–£2.3bn for 2024, benefiting from improved efficiency across the business. As discussed, in Civil Aerospace, Rolls Royce has shifted its focus towards high-margin aftermarket services rather than the lower-margin new engine sales. In 2023, nearly two-thirds of the £1.5bn increase in Civil Aerospace operating profit came from the aftermarket segment. This change in dynamic should continue supporting earnings growth over the coming years.

While Civil Aerospace has been the star of Rolls Royce’s recovery story, its Defence division continues to provide stability—and is one that is increasingly well-positioned for growth. The business, which supplies engines and propulsion systems for military aircraft, naval vessels, and land-based defence applications, is benefiting from rising global defence budgets and heightened geopolitical tensions.

Rolls Royce Defence has secured key contract wins that provide long-term revenue visibility. Among the most significant is the multi-billion-dollar deal to supply F130 engines for the U.S. Air Force’s B-52 fleet as well as on the UK’s next-generation nuclear submarine program, which will see Rolls-Royce’s nuclear propulsion expertise play a critical role in national security.

Source: Rolls Royce H1 2024 Results Presentation

A structural shift in global defence spending has likely strengthened the division’s outlook. European nations are under increasing pressure to ramp up their military budgets, driven by geopolitical instability and concerns over NATO’s future. US President, Donald Trump, has been calling for an increase in NATO’s spending target from 2% to 5% of GDP.

In Denmark, for example, defence spending is now set to rise by over 70%, while Italy and France are also pledging more resources to military programmes over the coming years.

Regardless of the final outcome, the direction of travel is clear: defence budgets across Europe are rising, and Rolls Royce is well-positioned to benefit as a key supplier to major Western military programs.

The Power Systems division, while less profitable and more cyclical, is also seeing strong demand in the data centre and governmental segments.

Operational Turnaround Under New Management

Since taking the helm in January 2023, Tufan Erginbilgic’s leadership has been instrumental in reshaping Rolls Royce’s fortunes. His focus on tight cost controls, non-core divestments, and cultural transformation has reshaped the company’s financial profile.

Indeed, a key barometer of improving fundamental momentum and financial health, the Piotroski F-Score, sees Rolls Royce score an excellent 7/9. This highlights the company’s improving profitability, efficiency, leverage and liquidity metrics.

Tufan has also astutely guided the company into new markets, such as small modular reactors (SMR) to expand into nuclear energy, sustainable aviation for reducing carbon emissions, and unique power systems for AI data centre-driven infrastructure expansion.

Its small modular reactor (SMR) programme probably remains the most intriguing wildcard. Although still in early development, securing government backing or commercial contracts could provide a fresh catalyst for growth. Interestingly, the company has been selected as the preferred supplier for the Czech Republic’s SMR programme and has been shortlisted in the UK Government's competition to select and contract providers of our new nuclear power fleet.

The shift in focus to play to the company’s core strengths, whilst developing the foundations for high-growth areas that align with global megatrends, has been key to the company’s turnaround efforts.

A ‘New Era’ of Shareholder Returns?

With improving free cash flows, Rolls Royce has reinstated its dividend payouts, which was a key milestone for investors. The company has signalled a payout ratio of 30%, targeting a sustainable, yet progressive dividend policy.

At the current share price, the dividend yield may not seem like much (less than 1%), but there is ample dividend cover and potential to initiate other forms of returns.

Share buybacks are rumoured to be on the table. As many industry peers initiate large-scale buyback programmes, such as BAE Systems, Melrose Industries, Qinetiq and Safran, it may be up to Rolls Royce to now follow suit.

JPMorgan has suggested that the record-free cash flows being generated in the European aviation & defence industries have potentially ushered in a "new era" of share buybacks.

Potential for Further Upside?

Some analysts believe Rolls-Royce still has room to run. Panmure Gordon recently raised its price target from 665p to 820p, arguing that Rolls-Royce’s valuation multiple could re-rate closer to European and U.S. aerospace peers like Safran.

Morgan Stanley is also optimistic, keeping an overweight rating on the shares and raising the target price to 700p.

However, the valuation is where things get a bit tricky. At 631p, Rolls-Royce is trading at a forward P/E ratio of over 30x based on 2025 consensus EPS of 21p. That’s a steep multiple, even for a business with improving fundamentals and rapidly growing profits.

A forward price-to-earnings growth (PEG) ratio of 2.1 hints that any signs of growth rates faltering could be punished by the markets.

If Rolls-Royce fails to maintain its profit growth trajectory (especially with its outlook to 2027) or faces unexpected cost pressures, there could be a sharp correction.

Citi actually recently downgraded the stock from Buy to Neutral, citing concerns that it’s now approaching ‘fair value.’

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Supply Chain Risks

Like many industrial companies, Rolls Royce is still navigating supply chain disruptions from the pandemic. While these have eased compared to previous years, higher inventory levels and working capital pressures remain areas to watch.

One of the biggest challenges lies in the availability of critical components—particularly castings, forgings, and high-value aerospace materials. Any delays or bottlenecks in sourcing these parts can slow production, affecting deliveries and aftermarket services.

Another area of concern is labour shortages and wage inflation, which have affected suppliers across the aerospace sector.

The company has been good, so far, at maintaining strong relationships with its suppliers to ensure production stability, but any hiccups here could weigh on earnings.

Recent Director Sales

One of the best signals that Rolls-Royce was very undervalued came in the second quarter of 2022, when an initial wave of aggressive insider buying started. Several directors made substantial purchases—known as ‘cluster buys’—which continued until mid-2024, reinforcing confidence in the company’s turnaround.

However, more recently, insider activity has shifted the other way. Since mid-2024, the scale of the director purchases has significantly declined, and the largest transactions have been sales. While directors sell for various reasons, a trend reversal in insider activity is always worth monitoring. It doesn’t necessarily indicate a loss of confidence, but it could suggest a shift in sentiment that investors should keep an eye on.

Delivering on long-term targets

While the 2024 guidance is well understood, the real test will be whether Rolls-Royce can hit its medium-term targets. Management has set a goal of £2.8bn–£3.1bn in annual free cash flow by 2027, alongside continued margin expansion. Achieving this will require both strong execution and favourable market conditions.

One key question is whether the civil aerospace aftermarket can continue its rapid growth. The post-pandemic surge has been a major tailwind, but at some point, growth rates will normalise. Rolls-Royce also faces competition from independent MRO (maintenance, repair, and overhaul) providers, which could cap pricing power over time.

With such a sharp run-up in the share price, Rolls-Royce needs to deliver a strong set of results and a confident outlook to justify its current valuation. There are several key things to watch out for:

• FY24 Free Cash Flow: Likely to land at the top end of guidance (£2.1bn–£2.2bn). Investors will want to see if management upgrades the 2025 FCF target (currently £2.6bn).

• Operating Profit: Expected to be at the higher end of the £2.1bn–£2.3bn range.

• Dividends/Share Buybacks: A 5.2p dividend is expected, but any additional capital return (such as a buyback) could be a catalyst for further upside.

• 2025 Guidance: Current analyst estimates point to £2.6bn in FCF and £2.6bn in operating profit. If management raises these figures, it would be a very promising sign.

• Mid-Term Targets: Any commentary on progress towards the 2027 FCF target (£2.8bn–£3.1bn) will be closely watched.

• Balance Sheet: To see whether the company has moved into a net cash position, or will do so next year.

• Supply Chain and Cost Updates: Investors will want reassurance that supply chain constraints are manageable and that inflationary pressures are not eroding margins.

Conclusion

Under Tufan’s tutelage, Rolls-Royce has executed an extraordinary turnaround, shifting from a company in survival mode to a cash-generating aerospace leader. The combination of strong aftermarket revenues, cost efficiencies, improving profitability and a foray into new high-growth markets makes for a compelling investment case.

However, at nearly 30x forward earnings, expectations are now sky-high. While there may still be room for upside, particularly if the company raises 2025 guidance, the risk-reward balance is not as compelling as it was a year ago. Sometimes, you simply have to pay over the odds for quality, though.