The Rolls-Royce (LSE: RR) share price enjoyed a strong run in the second half of September. It closed yesterday at 140p, up 33% from a mid-month low of 105p.
As we enter the fourth quarter of the year, I’ll discuss the reasons behind the strong recent performance, what might influence the direction of the share price in the coming months, and whether I’d buy the stock today.
Expectations
In an article in early July, when the shares were trading at around 100p, I felt the outlook would be determined by progress or setbacks on a number of things the company was expecting for 2021 and 2022. Namely:
- Outcome of a tender for the US Air Force B-52 new engine programme in the second half of 2021
- Turn free cash flow (FCF) positive at some point during the second half of 2021
- £2bn of asset disposals by early 2022
- Annualised savings of over £1.3bn by the end of 2022
- Free cash flow (FCF) of at least £750m as early as 2022
What drove the Rolls-Royce share price in September?
There was very good progress in several of the above areas through August and September. For one thing, the US Air Force tender was successful. This means Rolls-Royce’s F-130 engine will power the B-52 fleet for the next 30 years.
There was also a string of good news on asset disposals. The company has signed an agreement to sell its Bergen Engines business for an enterprise value of €63m (£54m). It’s also agreed the sale of its 23% stake in AirTanker Holdings for cash proceeds of £189m. But the biggie — and a key element of the target of £2bn of asset disposals by early 2022 — is an agreement to sell its ATP Aero business for approximately €1.7bn (£1.45bn).
These positive developments followed on from well-received half-year results in August.
Cost savings and FCF
The results revealed good progress on the target of annualised savings of over £1.3bn by the end of 2022. Management said it expects to achieve in excess of £1bn savings in 2021 alone.
The company also reiterated its expectation of turning FCF positive before the end of 2021. However, it pushed back the timeline of the £750m FCF target. Management said: “Based on current industry forecasts for the pace of recovery in international travel, this is likely to occur beyond the initial expected timeframe of 2022.”
The company had said all along that the timeframe would be dependent on the pace of the recovery in engine flying hours, and the market took the news of the likely delay in its stride. The shares ended the day 6% up on the back of the results.
Finally, outside of company announcements, the Rolls-Royce share price (as well as those of airlines) received a fillip from the recent US announcement that it’ll be relaxing travel restrictions on visitors from the UK and EU from November.
The agenda for Q4
I’m not anticipating as much news in the final quarter of the year as we had in Q3. Having said that, while not listed in the financial calendar on Rolls-Royce’s website, the company is in the habit of releasing a pre-year-end trading update in November or December.
Hopefully, by then, management will be in a position to confirm the company has turned FCF positive. Sentiment and the share price could take a knock if it fails to meet this expectation.
A trading update could also tell us how close the company is to achieving the target of annualised savings of over £1.3bn by the end of 2022. I think it’s possible management could achieve this a year ahead of target.
Aside from the trading update, the sale of the Bergen Engines business is scheduled to complete on 31 December. So we could have a New Year’s Eve announcement confirming it’s gone through.
The transaction, and the completion of the sale of AirTanker (expected Q1 2022) and ITP Aero (expected H1 2022) are subject to certain closing conditions and regulatory approvals. A major setback, particularly on the big ITP Aero sale, could hurt Roll’s-Royce’s share price.
Finally, the external risks the company could face in Q4 include a reimposition of air travel restrictions. Rolls-Royce needs wide-body, long-haul aircraft flying because servicing these engines is a staple of its revenue.
The Rolls-Royce share price in context
The 33% uplift in the share price in recent weeks has extended its 12-month rise to 214%. Nevertheless, the stock remains far below its levels of three and five years ago.
The company has clearly made good operational progress and its targets have become increasingly within reach. The market and share price have responded positively. The question for me is whether the shares are now too highly priced, fairly priced, or still undervalue the company’s prospects.
How I’m valuing Roll-Royce
I’ve got my eyes on the medium-term prize of annual FCF of at least £750m. Management said this is “achievable in a 12-month period when engine flying hours exceed 80% of 2019 levels.”
This doesn’t seem too much of a stretch to me. Indeed, I’m confident we’ll get back to that 80% within a reasonably short timeframe. And ultimately go on to far exceed it in the years ahead.
In the past, when the market has seen good momentum and less uncertainty in Rolls-Royce’s business, it’s valued the stock on an FCF yield as low as 3.3%. At the end-of-September share price, the yield on £750m FCF is 6.4%.
As to where the share price goes in Q4, I think much will hinge on the reception of the pre-year-end trading update. There could be some turbulence on the way to the medium-term £750m FCF target. Indeed, there’s a risk the company could fall short. However, I think the current yield offers me a margin of safety against this. And very good upside if it meets or exceeds the target.
As such, I think Rolls-Royce’s shares are priced at a very buyable level for me.
