In early June, with Rolls-Royce (LSE:RR) shares trading for nearly 90p, Morgan Stanley said the British engineering firm was “the clearest example of mispricing” in its coverage. The US bank set a price target of 118p.
But now, nearly three months later, Rolls-Royce shares have fallen a further 10%. Today, the stock is trading around 76p.
So why are shares this engineering giant pushing lower and is this an opportunity to buy for big returns? Given the stock is 70% down since the beginning of the pandemic, maybe I could even double my money?
Headwinds
Rolls-Royce has faced several challenges in recent years, and the largest among them currently is debt. The business had net debt of £5.1bn as of June.
The firm is offloading business units and has raised around £2bn, which will be used, in part, to reduce the debt burden. Rolls is also on track to be free cash flow positive this year — and this should also help reduce debt.
Pandemic-induced challenges appear to be in the past now. The group took on more debt during the pandemic as the revenue it receives from flying hours plummeted following governments around the world placing restrictions on travel.
But broadly, civil aviation is recovering, and is expected to hit pre-pandemic levels in 2024. Meanwhile, its order book in defence and power systems is sizeable.
An improving outlook
Rolls-Royce is currently trading for around 30% of where it was five years ago. Getting back to those heights might never happen, but I do see considerable growth potential here. And there are several reasons for this.
It has a multi-billion-pound order book and that gives it good visibility going forward. It also earns a considerable proportion of its income from the defence sector, which tends to be more reliable. The company has existing contracts whereby it provides ongoing support to defence departments around the world, while increased global spending on security should lead to new business growth.
As noted, civil aviation is recovering, but there are also positive long-term trends. There are huge growth markets for aviation, including in fast-developing nations like India.
Moreover, there are considerable barriers to entry in the industry in which Rolls operates. India, under Modi, might be big on indigenous tech, but it’s hugely unlikely that an indigenous company could challenge Rolls’s offer in aviation.
The same logic can be applied in defence and power systems. Quality really does come at a premium.
Could the share price really double?
I definitely see a lot of upside with Rolls-Royce. The issue is, with business segments being offloaded and capex cuts, it’s hard to tell what profitability might look like in the future. Because of that, it’s hard to predict where the share price could end up.
Broadly speaking, I believe its long-term outlook is positive, and it’s important to note that there are no “significant” debt maturities until 2024. Rolls is also barred from paying dividends until at least 2023 as part of its loan terms.
I do see considerable growth from the current share price, but I accept there could be some more turbulence to come in the near term, especially with no dividend to make the wait easier. Doubling my money? Realistically, I can’t see that happening in the next three years.
