Rolls-Royce stock: The bull case is strong, but these risks could trigger a drop

Rolls-Royce share price has wavered in the past few days as the recent momentum stalled. It has dropped to 1,502p, down from the year-to-date high of 1,584p. While the company has some positive catalysts, several risks may drag it in the near term. 

Rolls-Royce Holdings business is doing well

RR stock has been one of the best success stories in the FTSE 100 Index as it jumped by triple digits from its lowest level during the pandemic. This rally happened as its key sectors like civil aviation, defense, and power continued to perform well.

The most recent results showed that its business continued doing well in the year’s first half, with the management boosting its guidance.

Its revenue jumped by 26% in the first half to £11.2 billion, with its free cash flow soaring to over £1.96 billion. This growth was important as the company faced a challenging period in the year’s first half as the US-Iran war led to flight disruptions. It also experienced substantial challenges as the cost of doing business rose because of the shipping disruptions.

The management expects that its growth will continue in the foreseeable future. It now expects that its operating profit will jump to between £4.7 billion and £4.9 billion this year. Its free cash flow is expected to jump to between £5 billion and £5.3 billion. Its guidance assumed that it will deliver between 550 and 600 engines, while shop visits will be between 1,480 and 1,550.

Rolls-Royce Holdings expects to continue benefiting from the ongoing artificial intelligence boom that has led to a surge in power demand. At the same time, it is continuing to boost its share buyback and its dividends. 

RR stock faces some major risks

Rolls-Royce stock, however, faces some major risks this year. First, the company’s valuation is stretched, which may make it less attractive to long-term value investors. It trades with a forward price-to-earnings ratio of 34, higher than the sector median of 20. This multiple is also higher than other faster-growing and high-margin companies like Nvidia and Micron. In a recent note, a Morningstar analyst wrote:

“Rolls-Royce may be one of the standout FTSE 100 success stories of the last few years, but its results were not quite so positive to warrant an increased fair value estimate.”

Second, there are signs that investors are tweaking their expectations about the small modular reactor (SMR) business. Top companies in the industry like Oklo and NuScale have plunged this year, with their short interest continuing to rise.

Rolls-Royce is widely seen as a top player in the industry, thanks to its history in the nuclear power sector. It has already received large orders from the UK and Sweden. The challenge, however, is when the business will become profitable.

RR stock chart | Source: TradingView

Further, the stock has formed three risky patterns that may hurt its performance. It formed a small double-top pattern at 1,585p and a neckline at 1,502p. This pattern often leads to a strong bearish reversal.

The stock also formed a rising wedge pattern, which is made up of two ascending and converging trendlines. Finally, the MACD indicator shows that the stock has formed a bearish divergence pattern, which happens when it is falling during an uptrend. 

These technicals suggest that the stock may drop further in the near term. If this happens, the next level to watch will be the 50-day moving average of 1,442p.