Are Rolls-Royce shares “abnormally cheap”?

Image source: Getty Images

Rolls Royce (LSE:RR) Stocks have rewarded investors over the past six months as the stock nearly doubled in value.

But that’s only part of the story. THE FTSE100 The engineering giant has shown considerable volatility since the start of the pandemic. Amid choppy conditions, business unit sales and new ventures, the market essentially struggled to value the company.

What’s next for Rolls?

Abnormally cheap

swiss bank UBS upgraded Rolls-Royce last week to ‘buy’ from ‘neutral’. The Zurich-based company nearly doubled the price target to 200p from 105p and said Rolls shares were “abnormally cheap“.

Even despite the share price moving more than 40% since the fourth quarter results, Rolls still trades almost 2 points below its historical performance, at around 9% of the consensus on the flows of estimated available cash for 2024“, said the bank.

UBS pointed to the reopening of China as a major reason for its optimism about the direction of the stock price. He said the return from China – where jumbo jets using Rolls engines are flown on domestic flights – was a “underappreciated catalyst that could bring valuations back in line with historical norms”.

The bank pointed out that 51% of widebody traffic started or ended in Asia in 2019. China, according to UBS, accounted for 40% of the absolute reduction in widebody traffic in 2022 compared to 2019.

A multitude of catalysts

Figures released in February underlined that China’s civil aviation was back on track, jumping 34.8% year-on-year in January. Passenger numbers in January fell to 74.5 percent from the same period in 2019, according to the Civil Aviation Administration of China.

Air China said its passenger revenue increased 62.2% year-on-year in January, or 121.6% month-on-month.

But it’s not just China. Airlines around the world are betting on a strong recovery in civil aviation. Lufthansa And Indian water are among those expecting higher profits this year.

This is significant, as civil aviation has accounted for 45% of Rolls’ revenue over the past year. The engineering giant makes money through performance hours and engine maintenance, not just initial unit sales.

Geopolitical tensions have driven up global defense spending, which in the medium to long term should be a positive catalyst for Rolls’ defensive segment. Orders for electrical systems – the third of the three main business segments – increased by 29% to reach £4.3 billion in 2022.

Debt is certainly a problem for some investors. However, at £3.3bn – significantly lower than the same period last year – the debt burden looks more sustainable, although I understand repayments will weigh on profitability.

And as UBS pointed out, supply chain risks could impact cash flow in 2023.”We believe management’s cash flow forecast for 2023 is a key risk; failing or demoting here would reset the reputation boost gained so far“, it said.

For me, there are a multitude of positive catalysts here. There is plenty of evidence that the stock price could push higher still. That’s why I buy more.


Leave a Reply

Your email address will not be published. Required fields are marked *