Rolls-Royce Holdings PLC (LSE:RR.) was hit by a rare downgrade on Tuesday, sending shares down by 1.1%.
Berenberg has moved the engineer, which was the top performing FTSE 100 stock in 2023, to ‘sell’ from ‘hold’.
It thinks some of the drivers of Rolls-Royce’s margin expansion outlook through to 2027, which mostly relate to currency and favourable mix and base effects, will reverse thereafter.
“What happens from 2027, when several of these tailwinds should reverse, will be key for the intrinsic valuation, in our view,” the bank said.
“Pricing, the most important factor for intrinsic valuation, will be a challenge, given current reliability issues for key engines, which serve an airline industry that typically operates on low margins and appears to be approaching peak earnings,” it added.
Berenberg noted that new CEO Tufan Erginbilgiç is often presented in an “Elon Musk-like aura”.
But, while impressed by Erginbilgiç, and sharing his strategic view, Berenberg thinks it is still early days in terms of execution.
It is also "surprised at how sanguine the market is about the issues facing the XWB-97 engine (which powers the A350-1000) when operating in 'non-benign' environments, ie hot/sandy locations".
"If history is a guide, this is the kind of issue that can derail medium-term margins for companies in the jet engine business," the broker said.
Berenberg said as a result it views the risk/reward on Rolls-Royce as “unfavourable”.
The bank has a price target of 240p per share for Rolls-Royce.