The market gave a thumbs down to annual results from Rolls-Royce (LSE: RR) this morning. The shares fell as much as 5.5% in early trading after the aerospace giant reported a £2.4bn loss for 2018. It also said it’s pulling out of the competition to supply engines for Boeing‘s new mid-sized aeroplanes.
When I last wrote about Rolls-Royce, around this time last year, I posed the question: Is there a better FTSE 100 turnaround stock? I concluded that management was capable of delivering on its strategy for recovery, and that the share price had “potential upside of in excess of 50% on a two-to-three year view.”
Here, I’m going to look at what the company’s latest results tell us about the progress of the business. I’ll also update my view on where I think the share price could be heading from its current level.
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Solid underlying progress
The famously-named marque delivered strong top-line growth in 2018, with reported revenue up 7% and core revenue up 10% to £14.3bn. The £2.4bn bottom-line loss came as a result of booking a raft of hefty exceptional charges.
These included a £790m charge for technical issues with its Trent 1000 engines, with a contribution to customer disruption costs over £200m higher than previously anticipated. However, technical fixes for the engines have been identified and the company said it’s making good progress on implementing them.
Setting aside the challenges and exceptional charges of 2018, chief executive Warren East reported “solid progress” in the business, and underlying financial results “ahead of expectations.” Core free cash flow more than doubled to £641m, and East said following a restructuring announced in June, “we are starting to see the crucial behavioural changes needed to sustain our momentum.”
The company gave guidance for an increase in free cash flow to £700m (+/- £100m) for 2019 and “at least £1bn” by 2020. He expressed confidence both for the year ahead and the company’s mid-term ambitions. I’m convinced the business has a bright future, but what of the outlook for investors at the current share price?
Great value
The shares were trading at just above 800p when I rated the stock a ‘buy’ a year ago, with the aforementioned suggested potential upside in excess of 50% on a two-to-three year view. Having reached a high of 1,100p last year, the shares are currently changing hands at around 950p.
My upside calculation was based on Rolls-Royce’s previous annual free cash flow peak of £781m in 2013 and peak share price of comfortably above 1,200p. If the company looks like delivering free cash flow towards the upper end of its 2019 guidance of £700m (+/- £100m), I think we could see a 1,200p share price by the end of the year. This represents a potential upside of over 25% from the current 950p. And there could be more to come in the medium term, if free cash flow breaks through the £1bn that management’s targeting for 2020.
Rolls-Royce still has work to do to get the business firing on all cylinders and, of course, as the Trent 1000 engine issues show, there’s always a chance of a setback. However, with the underlying business and financial progress of 2018, and management’s confident outlook, I continue to see a great value risk/reward proposition for investors today. As such, I continue to rate the stock a ‘buy’.
