Aeronautical engineer Rolls-Royce (LSE: RR) has had a challenging couple of years. With demand for aircraft engine servicing plummeting during the pandemic, the company saw profits collapse last year. The Rolls-Royce share price has had a rocky ride, but it’s shown signs of recovery lately and is up 25% over the past year.
What’s next for the company and its share price? Here I consider whether it could climb to £1.50, around 35% above its current price.
Business tailwinds
The business has shown promising signs of gradual recovery. In its interim results this month, it turned a £1.6bn underlying operating loss in the first half last year to a profit of £307m this time around. It wasn’t all good news, by any means, and revenue slipped compared to the equivalent period last year.
As demand for civil aviation continues to recover, there should be heightened demand for the company’s engine servicing. Airlines in recovery mode may also start to consider buying new aircraft, all of which need engines. One of the advantages Rolls-Royce has as a company is that only a few aircraft engine makers exist and the barriers to entry in the industry are high. That helps give Rolls-Royce pricing power. I think that could help it boost profits in years to come.
The Rolls-Royce share price and cash flow
One of the drivers for the Rolls-Royce share price is the company’s free cash flow. That is different to earnings. Earnings are purely an accounting measure but free cash flow tracks the amount of hard money coming into – or leaving – a business. Free cash flow helps boost liquidity. While Rolls-Royce has bled cash over the past eighteen months, the company expects to become free cash flow positive in the current half-year period. It maintained this estimate in its interim results, which I take as a sign of management confidence.
Free cash flow positivity could help to boost the Rolls-Royce share price in my opinion. Last year the company diluted shareholders by issuing new shares to raise money. There is a risk that it could do so again if it needs more liquidity. But free cash flow will help its liquidity, strengthening the firm’s balance sheet.
Valuing Rolls-Royce
£1.50 may sound a long way from today’s Rolls-Royce share price, but I think it is possible for the stock to hit that price. It’s actually well below the level at which the shares entered the pandemic. Admittedly Rolls-Royce is a different business now, scarred by the plunge in demand in its civil aviation division last year. But as it shows signs it is rebuilding, I think the share price could rise. The interim results were decent and the real test in my opinion will be the full-year results. If it really does return to free cash flow positivity, I expect the shares to rally. So a £1.50 Rolls-Royce share price is on the cards in my opinion, although as of now I do not see any specific drivers for such price appreciation in the next few months.
Meanwhile, risks remain. Further lockdowns and travel restrictions in some markets could hurt revenues. Any failure to deliver on the cash flow target – whatever the reason – could knock investor confidence, which could lead to a share price fall.
