The Rolls-Royce (LSE: RR) share price has been hovering around 100p of late. I think it’s possible I could double my money by buying the stock at this level. There are risks, which I’ll discuss, but I reckon they’re outweighed by the potential rewards.
Pandemic casualty
It’s no secret the Covid-19 pandemic has severely impacted Rolls-Royce’s business performance, share price and near-term outlook. Its Civil Aerospace division has been hit particularly hard. This division accounted for 52% of the group’s revenue in 2019, but 43% last year after sales slumped 37%.
Before the pandemic, management had expected Rolls-Royce to generate at least £1bn of free cash flow (FCF) in 2020. As things turned out, FCF came in negative to the tune of £4.2bn. However, the company was successful in securing additional funds, including from a £2bn rights issue. It ended the year with healthy liquidity of £9bn (£3.5bn cash and £5.5bn undrawn credit facilities).
Looking ahead
Rolls-Royce’s strengthened liquidity has provided some support for the share price and a good buffer for what management expects to be an FCF outflow of £2bn in 2021. It’s anticipated this outflow will be weighted towards the first half of the year. And that the group will turn cash-flow positive at some point during the second half as air travel recovers.
Beyond 2021, management believes positive FCF of at least £750m (excluding asset disposals) is achievable when engine flying hours exceed 80% of 2019 levels. It reckons it can achieve the FCF target as early as 2022. In the medium term, it’s aiming to return to a net cash position driven by FCF generation and £2bn of asset disposals.
Rolls-Royce share price and valuation
Rolls-Royce’s market capitalisation at a share price of 100p is £8.37bn. The FCF yield on £750m is therefore 9%. At times in the past, when the market has been enthusiastic about the outlook for the company, the FCF yield has been less than half its current level. For example, as recently as two years ago, with a market capitalisation of £18.5bn and forward FCF guidance of £700m, the yield was sub-4%.
To my eye, this makes Rolls-Royce’s shares look very cheaply priced today. If the market were to regain a positive outlook on the business’s prospects, and push the share price up to rate it on the kind of FCF yield we’ve seen in the past, I think I’d have every chance of doubling my money from buying the stock today.
Risks to the Rolls-Royce share price
Management’s base-case scenario of negative FCF of £2bn for 2021 is predicated on engine flying hours at 55% of 2019 levels. Its “severe but plausible downside scenario” assumes approximately 45% (similar to 2020).
I don’t see the severe scenario as an existential threat to the company. Management reckons it has sufficient liquidity headroom through to September 2022. However, a below-base-case FCF performance in 2021 would also cast doubt on 2022’s FCF target of £750m. I think this would likely keep Rolls-Royce’s share price depressed for some time.
In addition to uncertainty around the timing and pace of air travel recovery, a failure to execute on planned cost savings and asset disposals in a timely fashion could be a setback for the Rolls-Royce share price.
On balance though, I think the company’s good liquidity and high investment-return potential, if it delivers on its plans, make the stock very buyable for me.
