Jet engine maker Rolls-Royce Holding (LSE: RR) remains a premium British engineering company, but its recent share price performance has been bumpy, frustrating investors who hoped for a smoother ride. It currently trades at a whopping forward valuation of 60 times earnings, which would normally scare me away altogether, except that its earnings now look set to climb dramatically as well. Should you buy it today?
Rolling down
Rolls-Royce trades around 35% lower than it did five years ago, a poor performance although it has done much better measured over a decade, up 177% over 10 years. I believe this remains a strong long-term income and growth play with bounce-back potential.
Remember 2015? That year, Rolls-Royce issued its fifth profit warning in 20 months, sparking an investor exodus amid fears of a sixth. In 2016, it cut its dividend for the first time in 25 years and warned of more job cuts. In 2017, a bribery settlement and the falling pound ended in a record pre-tax loss of £4.6bn.
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Turnaround play
Chief executive Warren East has been battling hard to turn the £15.3bn company around, trimming fixed costs, boosting margins, simplifying management structures, and improving the performance of its key civil aerospace division.
This year has seen fresh challenges, including potential fallout from the Saudi Arabian crisis, which threatens Rolls because the country is one of its biggest markets. There are also worries over how the slowing global economy will hit demand.
Engine trouble
Rolls-Royce, which makes engines for the Boeing 787 Dreamliners, Airbus A380 superjumbo, and the British nuclear submarine fleet, has been dogged by technical problems lately. In April, it was forced to increase inspections on 380 aeroplane engines amid fears they are deteriorating faster than expected. It then hit further turbulence in September after the in-flight shutdown of one of its engines on an Airbus SE A350 jet.
This has overshadowed the positive news that first-half underlying revenues grew 14% to £7bn, while the group swung back into the black, with underlying operating profit rising by £205m to £141m. However, it also suffered a £554m exceptional charge, due to problems with its Trent 1000 engine.
Cash flows
East kept analysts onside by reiterating his £1bn free cash flow target for 2020, and the company was recently on a PEG ratio of 0.3, which suggests it could offer good value for money. Yes, it does trade at a pricey 60 times forecast earnings, but that’s due to a forecast 71% drop in earnings per share in 2018, which is expected to turn into 159% growth next year, more than halving the valuation to 28.5 times.
The forecast yield is just 1.5% and covered just once that could take time to recover, with analysts expecting just 1.7% by the end of 2019. However, cover should have jumped to 2.2 by then, thanks to that earnings increase. So thereafter, we could have lift-off. Rolls-Royce will tempt investors who want to add a stalwart FTSE 100 long-term buy and hold to their portfolio. You might want to watch and wait for the next market dip.
