The Rolls-Royce Holding (LSE: RR) share price is at its lowest level in nearly three years. Problems with the Trent 1000 jet engine are causing short-term headwinds, but the group’s turnaround does seem to be making progress.
In this article I’ll look at the bull and bear arguments for this stock, and give my view on whether the shares are a buy.
Is Rolls a cash cow?
Chief executive Warren East has made free cash flow a central part of his guidance for the next two years. In 2019, East expects Rolls to generate free cash flow of around £700m. In 2020, this figure is expected to rise to £1bn.
The group’s market capitalisation is currently about £14bn. So £1bn of free cash flow would put the stock on a price/free cash flow ratio of 14. I’d see that as quite attractive, if it was sustainable.
Unfortunately, it’s not clear to me how sustainable this cash generation might be. You see, Rolls Royce reported free cash flow of £568m last year, which sounds encouraging. But this was helped by a £581m reduction in working capital.
What this seems to suggest is that Rolls is freeing up cash by paying its suppliers later and collecting payment on its own invoices more promptly. It’s a reasonable strategy, but these one-off gains can only take you so far.
Without this £581m cash inflow last year, free cash flow would have been negative. I’m concerned that free cash flow guidance for 2019 and 2020 may also rely on working capital gains, rather than stronger cash profits.
I’m not yet convinced that Rolls Royce is a cash cow.
More adjustments than a F1 car
East has made an effort to make the business easier for investors to understand. But the reality is that the accounts remain complex.
The firm’s half-year accounts show no fewer than three sets of figures. Investors were invited to choose from “underlying group”, “underlying core” and “reported group” numbers.
Depending on which set of figures you choose, revenue for the half-year varied from £7,213m to £7,883m. Operating profit for the same period might have been £83m or £203m.
Use of adjusted figures is commonplace. But Rolls makes a lot of adjustments, in my opinion. When combined with the complex accounting of its long-term engine service contracts, I find it very hard to get a true feel for the underlying profitability of this business.
Still flying too high?
City analysts tend to get good access to big companies like this and spend a lot of time understanding their business models. So perhaps we should use their figures as a guide.
Consensus forecasts for 2019 suggest Rolls will generate adjusted earnings of 19.1p per share. For 2020, this figure rise by 64% to 31.3p. These estimates put the stock on a forecast price-to-earnings ratio of 38 for 2019, falling to 23 in 2020.
For me, these figures are still too high. Although this business has a big market share and lots of valuable technology, I can’t get comfortable with the valuation. I just can’t get a clear understanding of what to expect over the coming years.
For now, I’m staying away. I don’t think Rolls is especially cheap, and I don’t expect the shares to double in the near future.
