Six months ago, we were wondering whether the Rolls-Royce Holdings (LSE: RR.) share price might fall below 50p.
Today, it’s spiked above 150p and shows no sign of stopping. What a difference a short time can make.
So is this finally the start of the long-awaited recovery? Or are we looking at a dead cat bounce, and might Rolls shares fall back again?
It pays to look at the bigger picture. The share price might have just rocketed. But it’s still barely above the levels it reached in late 2021.
Volatility
That uptick didn’t last long, and the price crashed back down again. So it pays to be cautious and not leap aboard without doing our research first. It could happen again.
But I’m optimistic that this really could be the start of longer-term gains for Rolls-Royce shareholders. After all, the shares are still 35% down since the pandemic struck. And down 50% over the past five years.
What do I think is different now? I reckon a good bit of the uncertainty surrounding the future for the aero engine business is lifting.
We need cash
For several years, we’ve had hopes of a return to positive cash generation. And then, with FY22 results released in February, the hopes turned to reality.
Rolls-Royce posted an impressive £505m in free cash flow from continuing operations. And that marks the key turnaround I was waiting for.
I think the company has done extremely well in focusing on its debt, and reducing it by £1.9bn in 2022. But that’s been funded largely by disposals.
Sustainability
For the trend to be sustainable, we need future reductions to come from operating cash flow instead.
The Rolls board expects free cash flow of £0.6bn-£0.8bn in 2023, which should hopefully send debt falling further.
That guidance depends on large engine flying hours reaching 80-90% of 2019 levels. I’d say there’s a fair bit of risk there, with the global outlook so uncertain right now.
There’s also a risk that the share price could fall back due to profit-taking.
Anyone who bought the day before the results were released is sitting on a gain of nearly 50%. It must be tempting to cash in and pocket some of that.
Remaining debt
Debt is also still a problem. Cash used to pay it down is cash that can’t go into the research and development of the next generation of engines.
Debt also skews the stock’s fundamental valuation.
Forecasts put Rolls-Royce shares on a 2023 price-to-earnings (P/E) ratio of over 30. That might look steep.
But if earnings growth comes off as expected, it should halve to around 15 by 2025.
Reaching 200p?
What about my mooted £2 share price target? It would lift the forecast P/E of 15 to 19. I still don’t see that as too stretching, especially if debt falls further by then.
In the end, though, I don’t care too much about what happens in 2023. For me, it’s all about long-term expectations.
And I’m starting to like what I see.
