The Rolls-Royce Holdings (LSE: RR) share price enjoyed a 12% bounce on Tuesday. I’m guessing this was because hopes are rising that the end of lockdown will herald a return to the air for the world’s airlines.
Rolls-Royce shares have fallen by more than 50% this year, as the firm faces a massive slowdown in demand for new aircraft engines. But I’m starting to think this sell off has gone too far.
As I’ll explain, I think Rolls-Royce shares could offer good value at current levels.
Airlines face a big hit
Rolls’ civil aerospace business makes jet engines for widebody passenger aircraft. These are typically used for long-haul flights. It’s one of only two major players in this sector, with a big share of the market.
The firm only expects to deliver “around 250” new widebody engines this year, compared to previous expectations of 450. To accommodate this reduction in demand, the group is planning to cut 9,000 jobs from a total global workforce of 52,000. It’s not hard to see why the Rolls-Royce share price has slumped.
However, while this is devastating news for the employees involved, the new engines delivered this year should still help to support the firm’s installed fleet of engines around the world. This is important, because most of the profit on engine sales comes from after-sales services, such as maintenance.
If aircraft start to return to the skies over the coming months — as seems likely — then revenue from these service contracts should start to recover.
Get jet engines for free!
I think investors selling Rolls’ shares are putting too little value on the group’s other businesses. You see, Rolls-Royce has three other big divisions, all of which generated significant profits last year.
The strongest of these is defence. This business generated an operating profit of £415m in 2019 and is said to have traded well through the coronavirus pandemic, with “an unchanged outlook” for 2020.
Two other important sources of profit are Power Systems, which makes engines and generators for industrial use, and ITP Aero, which makes gas turbines and smaller aircraft engines. Together, these operations generated a profit of £468m in 2019.
Although profits are expected to be lower this year, I think these three divisions are valuable enough to justify Rolls-Royce’s £6bn market-cap without the group’s troubled civil aerospace business. In other words, I think anyone buying the stock today is getting the civil aerospace business thrown in almost for free.
The Rolls-Royce share price looks cheap to me
Warren Buffett famously said that investors should “be greedy when others are fearful.” I think the fear surrounding the aviation sector is likely to provide buying opportunities. And although I probably wouldn’t buy airlines right now, I don’t think we’re going to stop flying.
If I’m right, then Rolls-Royce’s engine technology will remain valuable for many years to come.
Broker forecasts suggest that Rolls’ profits will recover sharply in 2021. City analysts expect the firm’s adjusted earnings to fall to 12p in 2020, before doubling to 25p in 2021. This would put the firm’s shares on a forecast price/earnings ratio of 12.5. I reckon this could be a good entry point for long-term investors.
