Why has the rally in Rolls-Royce shares gone into reverse?

Until a few days ago, everything looked good for investors Rolls-Royce (LSE: RR) like me. Shares of Rolls-Royce rose over 70% between October and the end of last month.

But the past few days have seen the shares begin to slide again, losing 7% in five days. That follows downbeat comments reported by the new chief executive less than a month after he put his foot on the table.

Good new running

The increase in the value of Rolls-Royce shares before the demotivating pep talks reflected a lot of optimism about the prospects for demand in civil aviation. The world has opened up, with China’s recent pandemic lifting many restrictions.

Closer to home, airlines are in tears. In its latest reported quarterly results, British Airways‘parents IAG and easyJet both saw slightly higher revenue than in the same pre-pandemic 2019 quarter. Ryanair and Wizz far beyond the pre-pandemic revenue.

I think that helps explain the recent surge in Rolls-Royce shares. Rising air travel could lead to demand for new engines and greater service profits from the company’s installed base.

The following concerns

But in an industry that sells expensive products such as aircraft engines, profit is not a major concern for these companies. However, it turned it into a profit. Rolls’ top line last year was £11.2bn which, although still below 2019’s equivalent of £16.6bn, is still plenty.

But profit after tax was £124m, making profit margins a measly 1.1%. That leaves little room for error and is not appealing to me as an investor. Last year’s profit followed three consecutive years of heavy losses in the engineer.

Profit margins can often be improved by cutting costs in a business and the new chief executive appears to be planning to do just that. But the company has a large cost-cutting program in 2020. In a highly skilled, capital-intensive industry where reputation for quality is important, cost-cutting involves a careful balance.

In addition, I fear that the cuts could lead to dissatisfaction among staff at a time when wage inflation is already a huge risk to profits in the company.

My step in the stock

In other words, as an investor, I’m nervous about the apparently aggressive new tone of Rolls-Royce’s new leader, especially when addressing the internal audience to most of whom are still strangers.

If the chief executive can prove that the approach helps the company to boost profitability dramatically, I show Rolls-Royce can respond by moving up again. So, the recent stock price reversal can only be temporary.

But there is substantial execution risk. Making your workforce feel nervous about job security just weeks into opening a company doesn’t sound like a smart way to run a business.

For now, I plan to keep the stock. I think the company’s installed base and expertise in an industry with high barriers to entry can hopefully be the basis of future success. But I will keep an eye on whether the leadership really helps its recovery, or just hollows the engineer out for short-term financial gains to the potential detriment of long-term investment cases.