Rolls-Royce (LSE:RR) shares have really bounced back since their nadir in late 2022. But I’m still expecting to see the engineering giant continue gaining this year despite some foreboding comments from its new CEO, Tufan Erginbilgic.
So let’s take a closer look at why I’m backing Rolls to continue soaring.
“Our last chance”
Erginbilgic began his tenure by labelling the engineering group a “burning platform” and said “given everything I know talking to investors, this is our last chance”.
That probably isn’t what I was expecting from the incoming CEO, and it seems to have brought the most recent bull run to an end. The stock is now down around 3% from its January peak, and remains down 5% over 12 months.
Erginbilgic described the company’s performance as unsustainable, adding that the situation had nothing to do with Covid-19. However, he contended that it was possible to turn the firm’s fortunes around.
Near-term positives
We’ve heard for a while now that Rolls-Royce’s defence and power systems segments have been performing well. But the big challenge has been civil aviation in the wake of the pandemic — the segment is its bread and butter, accounting for more than 40% of its total revenue.
In the autumn, the engineering giant said that Large Engine Flying Hours had only recovered to 65% of 2019 levels. The firm earns money from engine performance hours, and not just the sale of engines.
So where are the positives? Well China’s reopening represents a huge boost. International travel between China and the rest of the world will pick up — Emirates’ CEO recently talked of huge pent-up demand for travel in the country — but airlines in China frequently use wide-body jets with Rolls engines for domestic flights.
Because of this, I’d expect to see flying hours return to near-2019 levels this year.
The impact of China’s reopening has been feeding through to the forecasts and City analysts now believe profits will rise from £47m in 2022 to £278m in 2023. Further growth is expected in 2024.
Valuation
Rolls isn’t easy to value right now. It hasn’t consistently turned a profit since the pandemic hit and after the sale of business units to pay down Covid-induced debts, it’s a very different beast today.
Discounted cash flow models suggest that it could be undervalued by as much as 70%. But currently, I’d suggest forecasting cash flow over the next decade has been made even more challenging by the company’s transformation into a leaner, less indebted business.
Instead, I’ve been looking at near-term metrics. And they’re largely positive. Rolls trades with a enterprise-value-to-sales ratio of 1.2 versus a sector average of 1.8. Meanwhile, the forward EV-to-EBITDA is 10.2 versus a sector average of 11.5.
So, while I already own Rolls stock, this gives me the conviction to buy more.
