The Rolls-Royce (LSE: RR) share price hit a 17-year low of 113.6p just three weeks ago. In an article at the time, I explained why I saw it as a contrarian investment opportunity.
Since then, the share price has doubled. In fact, more than doubled. At 240p, as I’m writing, it’s up 111%. Would I still buy the stock at this price? Or is it a better idea to cash out and bank a profit?
Rights issue
On 30 September, Rolls-Royce shares closed at a price of 130p. The following day, the company announced its intention to do a 10-for-3 rights issue at 32p a share to raise approximately £2bn. This is subject to approval by shareholders at a meeting tomorrow (27 October), but I expect it to receive overwhelming support.
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What the rights issue means is that anybody already owning the shares or buying them before the ex-rights date (Wednesday 28 October) will be entitled to buy 10 shares at 32p each for every three they hold.
The £2bn raised will strengthen Rolls-Royce’s balance sheet. It will help it “weather macro-economic risks”, including what management calls any “reasonable worst case scenario”, before “we return to strong cash generation, expected in 2022”.
The market was initially unimpressed and the shares hit that 17-year low of 113.6p.
Why I liked the Rolls-Royce share price at 113.6p
If you bought at 113.6p and took up your 32p 10-for-3 rights entitlement, the average buy price for all your shares would be around 51p. This is actually what the market — at the time — was pricing the shares to trade at ex-rights. It’s known as the theoretical ex-rights price (TERP).
I felt the 51p TERP was far too cheap, particularly with Rolls-Royce’s strengthened balance sheet.
I wrote: “The company is targeting FCF [free cash flow] of at least £750m as early as 2022. According to my sums, based on the post-rights issue number of shares, this equates to 9p a share FCF. At the aforementioned average 51p buy price, the FCF yield is a highly attractive 17.6%”.
I didn’t think the market would come round to my way of looking at the company as quickly as it has. If I’d followed my own advice and bought at 113.6p (sadly I didn’t), I’d be quite happy to forego my rights entitlement and bank a quick 111% profit on my 113.6p-a-share buys at the current 240p price.
Expect the Rolls-Royce share price to plunge
Buyers of Rolls-Royce shares on the ex-rights date and beyond will no longer have the valuable entitlement to buy 10 shares at the discount price of 32p for every three they own. As such, expect the Rolls-Royce’s share price to plunge on the ex-rights date. The TERP at the current 240p price is 80p.
Is there still value in buying the stock at 240p today and taking up the rights for an average buy price of 80p? Well, at 80p, the FCF yield is down to 11.25%, compared with 17.6% when I rated the stock a buy. On balance, I feel inclined to avoid Rolls-Royce at this stage and await developments after the rights issue has played out.
