When I look over the punished shares in the FTSE 100, some seem clear bargains. But on fundamental ratios alone, Rolls-Royce (LSE: RR) does not look obviously cheap.
The aerospace giant’s earnings troubles are set to continue through this year, though the markets are expecting a significant rebound next year. But that would still put the shares on a 2019 P/E of 29, which looked at in isolation does appear a bit excessive.
But at this stage, that valuation surely can’t reflect the long-term promise for Roll-Royce’s recovery. And seeing it as a company that’s really not used to having downturns at all, with what I think is top quality management at the helm, I do think that promise is there.
Roland Head, writing about the company’s recent trading update, pointed to chief executive Warren East’s free cash flow target of £1 per share in the medium term. It’s an ambitious target, but if it’s achieved then I agree it would make Rolls-Royce’s shares look good value today — and Mr East doesn’t strike me as a man who sets grandiose targets that he can’t attain.
On the Brexit front, the firm does have contingency plans in place in case the outcome is a poor one, and that includes “working with EASA to transfer design approval for large aero engines to Germany, where we already carry out this process for business jets.” The company did, however, assure us that it does not expect there will be any transfer of jobs as a result.
The company is also building up its inventories as a contingency measure, as the last thing shareholders need now is for work to be delayed because parts and materials can’t make their way through the feared mega lorry jams to and from the Channel.
Something that does please me is a predicted return to progressive dividends starting this year. At the halfway stage the company maintained its interim dividend at 4.6p per share, but analysts are forecasting a full-year payment of approximately 12.2p.
That would provide a yield of only around 1.5%. But, most importantly, it would be 4% up on last year, and a rise ahead that’s significantly ahead of inflation is something I see as a sign of increasing confidence. And the mooted 13.9p marked in for 2019 would represent a further 14% hike. Again, not a big yield, but that kind of ambition this early in the firm’s recovery bodes well, in my view, for its future cash flow targets.
What’s the downside? It’s got to be global uncertainty, with big contributions from Brexit and from fears of an escalating trade war between the US and China. And even though 2019 earnings are predicted to come in at close to 30p per share, that’s still less than half of 2014’s figure. So we’re looking at what is very much a challenging turnaround, at a time when economic headwinds are troubling.
But over the longer term, aerospace trends should be very much in Rolls-Royce’s favour, with aeroplane production expected to grow strongly over the next decade.
It will surely take a few years for Rolls to get back to its traditional strength, but when you’re investing for your pension, there’s no rush, is there?
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Alan Oscroft 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.