I can’t resist an interesting turnaround stock. Right now, they don’t get much bigger or more interesting than Rolls-Royce (LSE: RR), whose share price has doubled since October.
Unfortunately, the aero engine maker’s performance hasn’t been so good over longer periods. Rolls-Royce stock is flat on a year ago, and down by 60% over three years.
With a return to normal now on the cards in many parts of the world, should I consider buying some Rolls-Royce shares for my Stocks & Shares ISA?
A turning point?
Rolls-Royce sells jet engines for airliners, but it makes most of its profits from aftersales maintenance and support services. When aircraft are grounded, airlines don’t need these services because the engines aren’t in use.
However, that situation is starting to change. Aero engineer Meggitt reports that domestic flying in markets such as the US and China has already rebounded strongly. Here in the UK, the government is expected to start lifting restrictions on travel to Europe in May.
It’s all good news. The only catch is that most of the routes opening up now are short-haul flights. Rolls-Royce engines are generally fitted to larger wide-body aircraft that are reserved for long-haul routes.
Rolls-Royce isn’t expected to return to profit until 2022. But the stock market always looks forward and I think we’re at a turning point. In my view, the outlook for Rolls-Royce will start to improve during the second half of this year.
What if we stop flying?
Rightly or wrongly, I don’t think environmental concerns will stop people returning to the air. Video conferencing is useful, but it’s no substitute for face-to-face business meetings with new people. Likewise, you can’t lie on the beach or visit foreign cities on Zoom.
For these reasons, I believe Rolls-Royce will see a gradual return to normal over the next couple of years. The pandemic has been painful for this FTSE 100 stalwart. But I think the changes made over the last year are likely to support stronger profits in the future.
The only concern I have about buying Rolls-Royce shares now is whether the price is right.
Rolls-Royce share price: too high or too low?
All the most successful investments I’ve made have had one thing in common. I’ve bought the shares at the right price. So how does Rolls-Royce stack up today?
On a short-term view, Rolls-Royce still looks fully priced to me. Broker forecasts suggest earnings of 4p per share in 2022. This prices the stock on 25 times forecast earnings.
However, earnings are expected to rise to 7.2p per share in 2023, which values Rolls on a more modest 14 times forecast earnings.
I can also see another attraction. The company hopes to start generating free cash flow (surplus cash) from its operations during the second half of 2021. CEO Warren East is targeting annual free cash flow of £750m in 2022, or soon after.
I reckon this will be enough to allow the group to start paying back some of the loans it’s used to survive the pandemic.
To be honest, I don’t know whether the Rolls stock will rise in May. But, on a longer-term view, I’d be comfortable buying Rolls-Royce while the share price is around 100p.
