Can Rolls-Royce share price exceed £ 2 in 2022?
Every time I see the Rolls Royce (LSE: RR) logo on the engine of an airplane in which I am about to fly, I feel reassured about its quality. However, such assurance has been rare for the shareholders of the company. The Rolls-Royce share price is currently near its 12-month high, but during that time it has seen periods of extreme turmoil.
Lately, stocks have skyrocketed. They have added 168% in the last year. Here is my take on whether the Rolls-Royce share price can continue to climb, hit the £ 2 level by the end of next year, and whether I would buy now.
Rolls-Royce: windfall or value trap?
The starting point for understanding the Rolls-Royce share price is to examine the demand in its primary civil aviation market over the past 18 months. Rolls-Royce makes money selling engines, but it also generally makes a lot of money maintaining those engines. Demand for civil aviation was decimated last year and maintenance activity suffered greatly.
This is true for a lot of companies – so why has Rolls-Royce been hit so hard? The answer lies in its business model. The construction and maintenance of aircraft engines is a capital intensive activity. Rolls-Royce had some of the levers that other companies used to reduce variable costs, such as downsizing. But its fixed cost base is large and difficult to reduce without hurting business prospects. Add to that its relatively undiversified nature. Competitors such as General Electric have been able to count on resilient performance in other areas of their operations as aircraft flying hours have decreased. Rolls-Royce had less of the ability to benefit from diversified income streams. Indeed, it is a structural challenge that I think could cause problems for the company again the next time there is a cyclical downturn in demand in civil aviation.
All of this had big implications for the Rolls-Royce share price, which fell. Some investors felt it offered excellent value, thanks to the company’s installed base, strong brand, engineering reputation, and limited competition in the aircraft engine industry. But other investors marked the price lower, fearing a value trap. It has had to deal with massive cash outflows, uncertain future demand and questions about its business strategy.
Why has the Rolls-Royce share price increased?
So what has changed that might explain the recent stock price surge?
There is no doubt that the fundamental performance of the company has improved. After a heartbreaking period of losses and massive cash outflows, the company expects its free cash flow to be positive in the current half of its fiscal year. The company has reduced many costs as part of an extensive savings program. Civil aviation demand has also been in recovery mode, although more slowly than some commentators expected.
But is that enough to justify the rise we have seen in the share price? I am not so sure. You see, the demand for civil aviation has plummeted, but some of the company’s other activities, such as defense and energy, have remained fairly resilient. Falling demand for civil aviation has naturally hurt Rolls-Royce, but I think it’s a worrying sign that it has caused an existential crisis for the company. To improve its survival prospects, it has made considerable efforts to increase its liquidity. These included a rights issue, which raised funds at the expense of diluting existing shareholders. The company is also planning a £ 2 billion divestiture program.
A longer term vision
While this can help consolidate finances, it does mean that the future business will not benefit from the income streams of the businesses it has sold. Both movements, in my opinion, underscore the potentially financially precarious nature of the business model of the company in the event of an external crisis. That hasn’t changed, and the next time aviation is disrupted due to a pandemic, financial crisis, or some other demand-draining event, I wonder if Rolls-Royce will have to again resort to such measures.
But many investors are appreciative of an expected return to positive cash flow and the potential for sustained future earnings. They believed that the Rolls-Royce share price did not reflect the potential of the company. Its rise reflects optimism that with the return of demand for civil aviation, the company’s operations will recover. Added to this is the expected benefit of cost reduction measures taken during the pandemic.
Is the Rolls-Royce share price fully valued?
At its current price of around 140 pence, the Rolls-Royce share price is trading at a price-to-earnings ratio of around 26 times its adjusted pre-pandemic 2019 profit. I don’t think that’s good. Marlet. Additionally, while the adjusted salary was positive in 2019, the base salary was negative. This has been the case recently for most years. Rolls-Royce’s frequent losses before adjustment suggest to me that its business model was not solid even at the start of the pandemic.
Since then, the company has focused on survival, from building cash flow to reducing costs. This can help improve his financial situation. But this could be insufficient to boost the attractiveness of the economic model. Even if it hits pre-pandemic profit levels again – something I don’t expect this year, but could happen in 2022 – the price-to-earnings ratio looks high to me. I am particularly worried about the group’s liquidity. While that should be enough for now, if some other unexpected event causes demand to drop, what will happen? Last year’s rights issue had a dilutive effect – and the same could happen next time.
Rolls-Royce share price at £ 2?
Despite this, I think a Rolls-Royce share price of £ 2 could be considered in 2022, if not sooner.
It’s because I feel like a lot of investors don’t look at the business model of the business the way I do. Instead, the focus is on the business’s ability to advocate for divestitures and return to free cash flow generation. So good news on these fronts could push the share price up further, possibly beyond the £ 2 level. For example, when the company announces its annual results, if it has hit its free cash flow target, I would expect investors to applaud the news.
However, I am not adding the business to my portfolio. Its business model remains vulnerable to sudden declines and a future risk of dilution remains. It is not yet clear whether the reduction in costs is hurting the company’s ability to deliver high-quality work to its customers. While the Rolls-Royce share price may continue to skyrocket, I am not getting on board.
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Christopher Ruane does not hold any position in the mentioned stocks. The Motley Fool UK has no position in any of the stocks mentioned. The opinions expressed on the companies mentioned in this article are those of the author and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. At The Motley Fool, we believe that considering a wide range of ideas makes us better investors.