After rallying fairly substantially since its rights issue, the Rolls-Royce (LSE:RR) share price has fallen almost 30% from early December. Although there are many reasons for the decline, here is why I think the Rolls-Royce share price fell and what I would do given the decline.
Why I think the Rolls-Royce share price declined
Rolls-Royce recently gave a downbeat cash flow guidance. In late January, management released a trading update projecting worse-than-expected free cash outflows of around £2bn for 2021 as the recovery in the long distance flight market remains weak. In particular, management expects this year’s flying hours for wide body aircraft to hover around 55% of pre-pandemic 2019 levels versus the previous assumption of a rebound to 70% of 2019 levels. If the total flying hours for wide body aircraft remain weak, I think some investors will assume that the company will have a difficult time in achieving its 2022 free cash flow target of at least £750m too. If Rolls-Royce doesn’t achieve that target, the company won’t be as attractive in terms of valuation.
Also, the Covid-19 variants have become more of a problem recently, and some of the variants, such as a strain in South Africa, are less susceptible to vaccines. Because those variants will spread, the pandemic could potentially last longer given the lower effectiveness of many vaccines. If the pandemic lasts longer than expected, the recovery in the long distance flight market could take longer than expected too.
What I’d do
Given everything that’s happened to the Rolls-Royce share price, I’d hold off on buying the stock.
Although the company undoubtedly faces headwinds in slow recovery and the Covid-19 variants, I think management did the share issuance last year precisely for events such as this where the rebound might take longer than expected. As a result of management’s fundraising last year, Rolls-Royce has a substantial amount of liquidity that gives it some breathing room for an eventual recovery. As of the end of 2020, the company had approximately £9bn in liquidity. Given the vaccines, I think the long distance market will recover eventually. With all the cost cuts management has done, I think the stock has upside as a result.
I’d also hold the stock because I think the company will successfully go ‘green’. In addition to investing more in its power systems division, which is working on some green technologies, Rolls-Royce has potential to go green in terms of making electric plane engines.
If Rolls-Royce leads in that sector and management does well, I think the company could not only grow its sales, but also potentially grow earnings as well. The electric plane market could be a huge growth market in the future as battery technology improves and nations do more to lower their emissions.
According to Morgan Stanley, the electric air mobility market could amount to $1.5trn by 2040. In terms of electric engines, Rolls-Royce is among the current leaders. According to the company, in September of last year, Rolls-Royce completed the testing of a technology that could power the fastest all-electric plane in the world.
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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.