In early October, Rolls-Royce (LSE: RR) officially announced a rights issue with the aim of issuing 6.4bn new shares to raise £2bn. If approved, the equity raise will more than triple the number of shares, from 1.93bn to 8.37bn. Despite this dilution, the Rolls-Royce stock has approximately doubled since the announcement was made.
There are a couple of potential reasons for the rally in the jet engine maker’s shares. The market may have been expecting an even worse dilution when the company announced its intention of raising equity earlier in the year. Or, it may be that the a fundraise would give the the company a stronger balance sheet, which would in turn give it more certainty.
In addition to having a stronger balance sheet, there’s also another less obvious reason why I think Rolls-Royce stock surged. If management does a good job on the front, I think it could potentially lead to even higher prices too.
More flexibility in terms of asset sales
Given the Covid-19 pandemic, Rolls-Royce has struggled and its balance sheet has weakened substantially.
For the first six months of 2020, for example, the company reported a pre-tax loss of £5.4bn and negative free cash flow of £2.8bn. For the second half, management expects further negative free cash flow.
Making things worse, Rolls-Royce specialises more in making engines that power long-haul intercontinental flights. This category of travel might not recover as fast as shorter, regional flights.
As a result of the dour outlook, management has targeted a minimum of £2bn in asset sales to strengthen the balance sheet. The good news for shareholders, in my opinion, is that Rolls-Royce’s recent fundraise means management has more financial flexibility in terms of asset sales. Because it is no longer in such a bad position, there’s less need a ‘forced-sale’ discount, if any.
Rolls-Royce has said that it hopes to achieve positive cash flow sometime in the second half of 2021, and it might already have enough money to make it if current estimates hold. Given the jet engine maker’s market cap value of around £4.4bn, getting a slightly higher price for assets could affect the stock a lot.
As a hypothetical example, if management were to sell £2bn in assets at 30% above what the market expects, it would translate into a benefit of around 14% of Rolls-Royce’s market cap.
Foolish conclusion
Rolls-Royce’s surge since early October is huge for any stock. I think it is well deserved, given that it provides more certainty to the company and more financial flexibility in terms of asset sales.
Although management will still need to execute in terms of controlling costs, I think the worst could be behind the company if air travel begins to normalise as expected.
