2020 has been a very difficult year for Rolls-Royce (LSE:RR). The number of flying hours plunged during the pandemic. Demand for Rolls-Royce’s jet engine sales and service fell sharply as well. The Rolls-Royce share price declined substantially year-to-date, and the company has had to issue more shares and bonds to firm up its finances.
Lately, however, RR shares have rallied thanks to vaccine optimism. With the vaccines, many experts hope that things could return closer to normal in the developed world by the end of next year. Over the next several years, many hope the developing world will rebound as well. If that happened, the number of flying hours could increase and RR would benefit.
Given everything that’s happened in 2020, what’s next for Rolls-Royce as the year ends? Here’s what I think.
Rolls-Royce shares: management’s plan for the future
In terms of what’s next, management plans to continue to control costs and strengthen the balance sheet through asset divestment. Giving the projected cost savings and the projected rebound in flying hours globally, management has a target of at least £750m in free cash flow in 2022.
In terms of their strategy going forward outside of their existing business lines, management has a long-term goal of targeting the short-haul jet engine market and also expanding into renewables.
Expanding into the short-haul sector would open a larger potential target market for RR. That would bring more opportunities to generate free cash flow in the long run. In terms of its green energy push, RR CEO Warren East sees potential opportunities in zero carbon tech and renewables.
Is the stock a buy?
I don’t see Rolls-Royce shares as a bargain, given the current valuation and 2022 free cash flow projections. With all the uncertainty in aviation still remaining, I’m putting the shares on my watchlist. I’m bullish on air travel in the long term, and if there are unwarranted substantial dips in Rolls-Royce shares, I’d buy. Although I don’t believe RR is a bargain in terms of present free cash flow estimates, I nevertheless reckon there are potential upside drivers if certain things happen.
I think one upside driver would be how management does in terms of its low carbon strategy. Although the generous valuations might not last, many green energy stocks have high valuations even though they might not necessarily deserve them financially. If Rolls-Royce does a good job in its green efforts or it is perceived as much more green, it could gain a higher valuation too.
Longer term, I believe management’s success in controlling costs and growing into new markets matters a lot too. If management executes well in renewables and/or the short-haul market, I can see the company’s free cash flow outperforming expectations. If RR successfully and profitably grows outside of its existing markets, I think Rolls-Royce shares would be rewarding.
