Where will the Rolls-Royce share price go in July and beyond?

G A Chester sees a margin of safety and significant upside potential in the Rolls-Royce share price. He looks at the near- and long-term prospects.

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The Rolls-Royce (LSE: RR) share price closed above 125p on one day in March. But that’s as good as it’s got so far this year. It ended June below 100p. Longer term (three, five and seven years), the picture is even grimmer.

However, great companies can suffer quite extensive periods of underperformance. Look at Coca-Cola between 1998 and 2006. And look at what it’s done since. Could Rolls-Royce stage a similar recovery?

The Rolls-Royce share price in July

With half-year results not due until 5 August, short-term movements in Rolls-Royce’s share will be down to three things:

  • Unscheduled news from the company
  • Developments in the wider world that the market perceives as positive or negative for the business
  • Simple market ‘noise’ — fluctuations in the share price for no fundamental reason

Unscheduled news

In the first trading days of July, the Rolls-Royce share price has climbed back above 100p. This was probably helped by a Bloomberg report on an interview with the company’s engineering and technology director, Simon Burr, last Friday.

It seems Rolls-Royce is close to resolving the costly litany of glitches that have plagued its Trent 1000 engines. Bloomberg quoted Burr as saying: “After a difficult three or four years, I feel confident about the durability of the engines and the future.”

There’s further potential positive unscheduled news that could come as early as July. Rolls-Royce is awaiting the outcome on its tender for the B-52 new engine programme, “where a decision from the US Department of Defense is expected in the second half of this year.” There’s also a chance of a positive development in July on the company’s programme to raise at least £2bn from disposals by early 2022.

Of course, negative news in either of these areas — whether in July or later in the year — wouldn’t be good for investor sentiment.

The Rolls-Royce share price longer term

The August half-year results should provide some insights into the longer-term prospects for the business and the shares. Management has set a number of financial targets for the second half of 2021 and 2022. Principally:

  • Turn free cash flow (FCF) positive at some point during the second half of 2021
  • £2bn of asset disposals by early 2022
  • Annualised savings of over £1.3bn by the end of 2022
  • FCF of at least £750m as early as 2022

I’m optimistic management will be able to reaffirm these targets in the half-year results. If so, with the targets becoming increasingly within reach, I reckon the market and share price will respond positively. Mind, there’s risk. The FCF targets are “dependent on the pace of the recovery in engine flying hours and underpinned by the restructuring programme.”

Risk and reward

At the current share price, the yield on Rolls-Royce’s targeted £750m FCF is 8.6%. In more optimistic times, the FCF yield has been less than half this. Now, there’s a risk management’s expectations on the recovery in engine flying hours and FCF targets could turn out to be over-rosy.

However, with the size of the FCF yield offering both a margin of safety and significant upside potential, the shares look very buyable to me at their current level.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

G A Chester 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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