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Are Rolls-Royce shares the buying opportunity of the FTSE 100?


MongiIG

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Rolls-Royce shares could be an undervalued FTSE 100 opportunity after Morgan Stanley judges them ‘woefully mispriced.’

rolls royceSource: Bloomberg
 
 Charles Archer | Financial Writer, London | Publication date: Monday 20 June 2022 

Rolls-Royce (LON: RR) shares have long been the ‘jewel in the crown’ of the FTSE 100, with the company name a hallmark of quality.

Of course, it’s been a less inspiring investment choice, down 92% from its record 1,159p in December 2013, 73% in the past five years, and 30% year-to-date to 89p today.

However, Morgan Stanley thinks Rolls-Royce shares are ‘woefully mispriced.’ And encouragingly, the investment manager believes an earnings recovery ‘is much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery.’

Rolls-Royce share price: revenue recovery

Rolls-Royce’s revenue fell from £11.49 billion to £11.22 billion in 2021, with £4.5 billion derived from its civil aerospace division, £3.3 billion from defence, and £2.8 billion from power systems.

But the FTSE 100 company turned a 2020 £3 billion loss into a £124 million profit last year, as lockdowns ended and demand for travel surged. And it completed its £1.3 billion cost-cutting programme a year early, axed 9,000 jobs, and sold off ancillary businesses in a disposals programme that generated £2 billion.

However, net debt now stands at over £5 billion, driven by last year’s £1.2 billion spending on research and design, as well as the superlong investment cycles necessitated by the aerospace sector. This could become a problem as interest rates rise.

But CEO Warren East, who is stepping down at the end of the year, believes the company has ‘made significant progress on the path to recovery from the impact of COVID-19.’

Further, he expects Rolls-Royce will ‘achieve positive profit and cash this year, driven by the benefits of our cost reductions and increased engine flying hours in Civil Aerospace together with a strong performance in Defence and Power Systems, and balanced by our commitment to invest in technology and systems.’

rolls royce 2Source: Bloomberg

Where next for Rolls-Royce shares?

Rolls-Royce is a multi-faceted company with diverse revenue streams. The FTSE 100 stalwart enthuses it has ‘confidence on revenue, profit and cash conversion against the headwinds of inflation and supply chain risk.’

But as Chair Anita Frew knows, civil aerospace is the company’s golden goose, with long-term service agreements (LTSAs) on jet engines generating the lion’s share of the revenue.

And as revenue from this division has halved since the pandemic began, the Chair accepts ‘we have to improve the performance of civil…it’s the big beast within the business and it’s the one that really moves the needle.’

Encouragingly, LTSA flying hours increased by 42% year-over-year in the first four months of 2022, on the back of pent-up passenger demand across Europe and the Americas.

And as demonstrated by the chaos at airports across Europe, and various optimistic tones from management at airlines ranging from easyJet to IAG, flying hours could hit pre-pandemic levels by this time next year. Of course, with CPI inflation set to hit 11% in October amid a worsening cost-of-living crisis, future travel demand remains unpredictable.

Moreover, it’s possible that the Ukraine war will help increase revenue at its defence division. However, while it acquiesces that ‘governments are increasing their long-term budget allocations towards defence activities,’ it warns that it’s also ‘not immediately exposed to individual geopolitical events.’ But as the ghost of the Cold War apparates, the longer-term potential is difficult to ignore.

Then there’s the new markets business, which Rolls hopes will generate £5 billion of annual revenue by the 2030s. It’s made great strides: an all-electric plane breaking world records, the new ultra-efficient power gearbox, and good progress on small modular nuclear reactors.

In addition, it also benefits from strong political support due to its heritage status and government-owned golden share. PM Johnson and Business Secretary Kwarteng both appear particularly fervent supporters. And given the expensive nature of its business areas, the company is surrounded by a strong protective moat.

Of course, there’s the long-term problem with decarbonising air travel. And Frew could soon be at odds with investors over the appointment of the next CEO, with disagreements over whether he or she should have aerospace industry experience.

But with Morgan Stanley onside, civil aviation and defence demand increasing, and promising R&D investments, Rolls-Royce shares could now be a FTSE 100 buying opportunity.

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Morgan Stanley may say Rolls-Royce shares are ‘woefully mispriced’, but I do not think it is time to jump in for a bargain. Their view appears to be based mainly on an optimistic outlook of future earnings from a global aviation recovery.

The aviation sector, with greater demands on environmental costs, will be challenging. In defence, economic and national security will be high on western government agendas as they reassess future requirements. This is more likely to result in greater spending from which Rolls Royce should benefit.  Schell, President of the Power Systems division is to leave the company at the end of the year but on a positive note, the order book is said to be strong.

I do not think the fundamentals are aligned for a long-term buy. Looking at risk (liquidity and solvency) a concern is interest cover. More generally, the company’s Altman Z score should be a signal of concern. My measure of management effectiveness does not indicate either profitability or efficiency is yet in good shape. A return to profitability is good news but the lack of a dividend does not help the situation. Future growth looks promising and is important in helping assess value but they are estimates and for me, there is simply too much uncertainty around the company to buy at the moment or to think the company is significantly undervalued.

On the technical side, the long-term trend is still down, with the price settled around what I see as a support level.

From a long-term investment perspective, I do not think Rolls Royce is an immediate buy but possibly worth watching. A recovery stock requires stronger fundamentals than those Rolls Royce possesses right now. However, in the nearer term the price may yet return to the 135p – 140p levels we have already witnessed since the dramatic fall from 344p in early 2019, although a fair valuation probably sits around 100p.

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14 hours ago, Greenmantle said:

Morgan Stanley may say Rolls-Royce shares are ‘woefully mispriced’, but I do not think it is time to jump in for a bargain. Their view appears to be based mainly on an optimistic outlook of future earnings from a global aviation recovery.

The aviation sector, with greater demands on environmental costs, will be challenging. In defence, economic and national security will be high on western government agendas as they reassess future requirements. This is more likely to result in greater spending from which Rolls Royce should benefit.  Schell, President of the Power Systems division is to leave the company at the end of the year but on a positive note, the order book is said to be strong.

I do not think the fundamentals are aligned for a long-term buy. Looking at risk (liquidity and solvency) a concern is interest cover. More generally, the company’s Altman Z score should be a signal of concern. My measure of management effectiveness does not indicate either profitability or efficiency is yet in good shape. A return to profitability is good news but the lack of a dividend does not help the situation. Future growth looks promising and is important in helping assess value but they are estimates and for me, there is simply too much uncertainty around the company to buy at the moment or to think the company is significantly undervalued.

On the technical side, the long-term trend is still down, with the price settled around what I see as a support level.

From a long-term investment perspective, I do not think Rolls Royce is an immediate buy but possibly worth watching. A recovery stock requires stronger fundamentals than those Rolls Royce possesses right now. However, in the nearer term the price may yet return to the 135p – 140p levels we have already witnessed since the dramatic fall from 344p in early 2019, although a fair valuation probably sits around 100p.

Thanks for sharing @Greenmantle

 

All the best - MongiIG

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1 hour ago, MongiIG said:

Thanks for sharing @Greenmantle

 

All the best - MongiIG

It has excellent fundamentals, perhaps the balance sheet, the existing global economic situation or the fundamentals circulated shadows the company, it occurs whenever innovation does not target the individual, placing the products at the bottom of a virtual list or however considered NOT a priority, just a good read or a good watch.  

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39 minutes ago, RomPathsSwap said:

It has excellent fundamentals, perhaps the balance sheet, the existing global economic situation or the fundamentals circulated shadows the company, it occurs whenever innovation does not target the individual, placing the products at the bottom of a virtual list or however considered NOT a priority, just a good read or a good watch.  

Thanks @RomPathsSwap

All the best - MongiIG

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On 22/06/2022 at 11:36, MongiIG said:

Thanks @RomPathsSwap

All the best - MongiIG

I had the impression the company is divided in two: Automaker as subsidiary and Aerospace; For some reasons the author placed an auto image and aeroengines images in the same article, it could possibly be wrong, the fundamentals may differ.   

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