Whenever I see the Rolls-Royce (LSE: RR) logo on the engine of a plane I am about to fly in, I feel reassured about its quality. Such reassurance has been in short supply for the company’s shareholders, though. The Rolls-Royce share price is currently close to its 12-month high, but in that period, it’s had periods of extreme turbulence.
Lately the shares have soared. They’ve added 168% across the past year. Here’s my take on whether the Rolls-Royce share price can keep gaining altitude, reach the £2 level by the end of next year and whether I’d buy now.
Rolls-Royce: bargain or value trap?
The starting point to understand the Rolls-Royce share price is to look at demand in its core civil aviation market over the past 18 months. Rolls-Royce makes money selling engines, but it also usually makes a lot of its money servicing those engines. Demand for civil aviation was decimated last year and the servicing business suffered badly.
That’s true of a lot of businesses – so why was Rolls-Royce so badly hit? The answer lies in its business model. Building and servicing aircraft engines is a capital-intensive business. Rolls-Royce had some of the levers open to it that other businesses used to reduce variable costs, such as cutting staff. But its fixed cost base is large and hard to cut without damaging business prospects. Add to that its relatively undiversified nature. Competitors such as General Electric were able to rely on resilient performance in some other parts of their businesses when aircraft flight hours dropped. Rolls-Royce had less ability to benefit from diversified income streams. Indeed, that’s a structural challenge I think could cause the company problems again the next time there’s a cyclical demand downturn in civil aviation.
That all had big implications for the Rolls-Royce share price, which plummeted. Some investors felt that it offered excellent value, thanks to the company’s installed base, strong brand, engineering reputation and the limited competitive set in the aircraft engine sector. But other investors marked the share price down, fearing a value trap. It faced massive cash outflows, uncertain future demand and questions over its business strategy.
Why has the Rolls-Royce share price increased?
So, what’s changed which might explain the recent surge in the share price?
Undoubtedly the business’s fundamental performance has improved. After a gut-wrenching period of losses and massive cash outflows, the company expects to turn free-cash-flow-positive in the current half of its financial year. The company has stripped out a lot of costs as part of a wide-ranging programme of savings. Civil aviation demand has also been in recovery mode, albeit more slowly than some commentators expected.
But is that enough to justify the increase we’ve seen in the share price? I’m not so sure. You see, civil aviation demand fell, but some of the company’s other businesses, such as defence and power, remained fairly resilient. The drop in civil aviation demand understandably hurt Rolls-Royce, but I think it’s a worrying sign that it caused an existential crisis for the company. To improve its survival prospects, it made strenuous efforts to boost its liquidity. Those included a rights issue, which raised money at the expense of diluting existing shareholders. The company also planned a £2bn programme of disposals.
A longer-term view
While that can help shore up finances, it means the future company won’t benefit from the income streams of the businesses it has sold. Both moves, in my view, underline the potentially-financially-precarious nature of the company’s business model when an external crisis hits. That hasn’t changed, and when aviation next turns down because of a pandemic, financial crisis or some other event that drains demand, I wonder whether Rolls-Royce will again need to resort to such moves.
But many investors value a mooted return to positive cash flow and potential for buoyant future earnings. They thought the Rolls-Royce share price didn’t reflect the company’s potential. Its rise reflects optimism that as civil aviation demand returns, the company’s business will get back to health. Added to that is the expected benefit from cost-cutting measures taken during the pandemic.
Is the Rolls-Royce share price fully valued?
At its current price of around 140p, the Rolls-Royce share price trades on a price-to-earnings ratio of around 26 times its pre-pandemic 2019 adjusted earnings. I don’t think that’s cheap. Moreover, while adjusted earnings were positive in 2019, basic earnings were negative. That has been the case in most years recently. Rolls-Royce’s frequent losses before adjustment suggest to me that its business model wasn’t strong even coming into the pandemic.
Since then, the company has focused on survival, from shoring up liquidity to cutting costs. That can help improve its financial standing. But it might be insufficient to revive the attractiveness of the business model. Even if it reaches pre-pandemic earnings levels again – which I don’t expect this year, but could feasibly happen in 2022 – the price-to-earnings ratio looks high to me. I’m especially nervous about the group’s liquidity. While it should be sufficient for now, if another unexpected event means demand falls, what will happen? Last year’s rights issue was dilutive – and the same could happen next time round.
A £2 Rolls-Royce share price?
Despite that, I do think a £2 Rolls-Royce share price could be on the cards in 2022, if not sooner.
That’s because I feel a lot of investors aren’t looking at the company’s business model the way I am. Instead, the focus is on the company’s ability to raise case through disposals and return to free cash flow generation. So good news on those fronts could further boost the share price, perhaps beyond the £2 level. For example, when the company announces its full-year results, if it has hit its free cash flow target, I expect investors to cheer the news.
However, I’m not adding the company to my portfolio. Its business model remains vulnerable to sudden downturns and a future dilution risk remains. We’re yet to see whether cost-cutting damages the company’s ability to deliver high-quality work to customers. While the Rolls-Royce share price may keep soaring, I’m not boarding.
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Christopher Ruane 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.