Why I just turned bullish on the Rolls-Royce share price

As the Rolls-Royce share price trades for pennies, Andrew Mackie believes the company is undervalued.

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For the last two years, the Rolls-Royce share price has effectively gone nowhere. There have been bursts of optimism during that time but they all turned out to be false dawns. Each time I have revisited its investment case, I have decided against adding it to my Stocks and Shares ISA.

However, recently my views toward the firm have begun to soften and I am starting to see value at the levels the share price is trading at.

Aerospace – a key market

Rolls-Royce is a business comprised of four divisions: civil aerospace, defence, power systems and new markets. Although defence and power systems are highly profitable businesses, the reality is that only a recovery in its aerospace business is going to lead to any significant share price movement.

Civil aerospace accounts for 41% of group revenues. Breaking this down, two-thirds is accounted for by services, with the other third coming from original equipment. But it’s the underlying revenue mix by sector that is most telling. 72% is derived from large engines and 28% from business aviation and regional.

Domestic travel and business aviation recovered extremely quickly following the relaxation of travel restrictions. However, global international passenger traffic is not expected to reach 2019 levels until late 2024. This is not good news for Rolls-Royce.

Cause for optimism

Rolls-Royce has leading products in growing markets. In its wide-body portfolio, it powers four of the five new wide bodies, three of which are sole-source positions with Airbus. Amongst this range, over 90% of engine flying hours (EFH) are still ahead of it.

In the older ranges, Trent 700 is still relatively young with an average age of just 11 years. The company estimates that 40% of EFH is in the future.

When one considers that for every engine installed, it captures — through its life — 90% of the Services value, then each one is effectively a licence to print money.

The company is also tapping into the enormous freighter market, which is growing exponentially as a result of the pandemic. Freighter conversions are accelerating in the Airbus A330s – where over 85% of the available capacity for conversions is taken by Trent 700-powered engines. In the future, A350 conversions offer growth potential.

A smaller, leaner company

Let’s be under no illusion, Rolls-Royce still faces significant challenges. The pandemic forced it to undertake the largest restructuring in its history. It took a third of the cost base out through removing 9,000 roles, ballooned its debt position and diluted its existing share base. But without taking those actions, it would not have survived.

My fear has always been that such a painful restructuring has done irreparable damage. Corporate history shows that companies forced in to such action rarely ever re-capture past glories. But there is cause for me to believe that this might not be the case for Rolls-Royce.

A leaner, smaller organisation might actually benefit the company. A flatter organisational structure, process simplification, and a new mindset brought about by fresh talent has the potential to catalyse and propel it to exploit new opportunities. As the world becomes increasingly digital, its engineering heritage and innovation-driven culture are sources of competitive advantage. I believe that a recovery in the share price is only a matter of time and I will therefore be buying the stock soon.

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 considered so you should consider taking independent financial advice.

Andrew Mackie 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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