Rolls-Royce (LSE:RR) shares have traded just short of 150p for the last few weeks. The stock appears to have plateaued since early March following one almighty bull run. The stock is up a phenomenal 110% over six months.
The thing is, Rolls isn’t the easiest company to value at the moment. That’s because it’s still recovering from an existential shock — Covid-19. The FTSE 100 giant posted earnings per share of 1.95p for 2022, giving it a price-to-earnings ratio around 75.
So why do I think Rolls is a strong buy when the stock appears very challenging to value? Let’s take a look.
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High price targets
It’s not just me who thinks Rolls-Royce has further to rise. Over the past two months, banks and a credit ratings agency have strengthen their outlook on the UK engineering giant.
In early March, Swiss bank UBS nearly doubled its price target on Rolls to 200p from 105p. Its analysts said the shares were “abnormally cheap“, despite China reopening. One week later, Citi lifted its price target to 255p as it cited “a clear route to much better cash flow“.
Both these upgrades came after Rolls surprised to the upside with its 2022 full-year results. But, importantly, both these price targets are a long way above the current share price of 148p.
This was followed by Standard and Poor’s raising its rating for Rolls-Royce long-term debt to BB with a positive outlook. This means the company’s debt could return to investment grade standard over the next year-to-18 months.
Multiple tailwinds
Rolls-Royce has three main business segments — civil aviation, power systems, and defence. We’ve known for a while that power systems and defence have been performing well.
Geopolitical tensions have contributed to stable long-term growth in the latter. Meanwhile, orders for power systems — the third of the main business segment — were up 29% to £4.3bn in 2022.
Civil aviation is the biggest of these segments, and this is where the challenges were during the pandemic when planes stopped flying. That’s because Rolls earns money through performance hours and servicing, not just the sale of engines. The debt accrued during the pandemic resulted in the sale of business units to fund debt repayments.
But things are changing and civil aviation is booming. A major tailwind is the reopening of the Chinese market. In China, wide-body jets with Rolls engines are used on domestic flights. That’s not typically the case elsewhere in the world. According to UBS, China accounted for 40% of wide-body traffic reduction in 2022 versus 2019.
I’m aware that net debt remains problematic at £3.3bn, and this will continue to drag on profitability. However, with these strong tailwinds, this debt could become much more manageable.
Moreover, with these positives, I’m expecting cash flow to soar over the next 12 months. In fact, I’m anticipating revenue to exceed 2019 levels for the first time since the pandemic. That’s why I’m continuing to buy more Rolls stock.
