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Rolls-Royce shares surge? Here’s what I think needs to happen

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I was bullish on Rolls-Royce (LSE:RR) shares in October of last year. I thought the rights offering was a positive development as it would give management more flexibility in terms of getting a higher price for asset sales down the road. Turns out, Rolls-Royce shares have indeed rallied since October of last year when factoring in the share issue. 

While I was right on the stock’s movement, I was wrong on why it rallied. In the rear view mirror, it seems RR rallied due to the positive Covid-19 vaccine news from Pfizer and Moderna rather than the fund raise. Because the efficacy rates of the Pfizer and Moderna vaccines were a lot better than expected, expectations for a civil aerospace recovery have risen. 

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Although I may have been wrong in terms of why RR has rallied, I will nevertheless offer another fearless prediction that may or may not pan out: I think there is a decent chance RR will surge higher if the following events were to occur. 

Rolls-Royce shares: going green 

It’s no secret that green stocks are hot right now. 

Investors only need to look at fuel cell stocks and wish that Rolls-Royce shares could capture some of that magic. 

Compared to some of those stocks, Rolls-Royce’s fundamentals look like a Rolls-Royce car compared to a regular car. While many of the fuel cell stocks haven’t been profitable for a long time and don’t have many competitive advantages, RR has been profitable before the pandemic. RR also has a world class workforce, a trove of patents, and a sizable base of existing customers that is hard to match. Given RR’s Power Systems division, the company has potential to turn more green too. 

Given the current market optimism over green stocks, I think there is an opportunity. 

If Rolls-Royce is perceived as more green, I reckon the company could potentially gain a higher stock price (as long as the market remains optimistic on green stocks). If it gains a higher stock price, RR could use M&A and/or raise money from the markets to potentially grow earnings that generate long lasting value. 

To their credit, RR management is trying to take advantage of the situation by investing more in certain green areas. The company is also focusing more on its Power Systems division. 

If the market buys into RR’s green pivot, I think there is potential for the stock to surge in 2021. 

It should be said that any surge in Rolls-Royce shares due to the ‘green perception’ could be temporary without management to back up the optimism with earnings estimates. There needs to be execution in the long run.

Substantially better than expected execution and outlook 

Speaking of execution, I believe there is potential for Rolls-Royce shares to surge higher if management outperforms in that category. If earnings results meaningfully outperform and outlook exceeds expectations substantially, there is potential for a rally. 

Is the stock a buy?

Although its shares aren’t cheap any more given the current free cash flow projections for 2022,  I think a potential fundamental recovery is more certain given the Covid-19 vaccines on the market today. In the long term, I like RR given its exposure to the long-term growth of air travel and the company’s wide moat. 

I’d hold the stock if I were an existing shareholder. If there are dips in the stock, I’d buy it.

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Jay Yao has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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