2023-06-28 00:18:26 ET
Summary
- Rolls-Royce has emerged from a challenging few years and returned to positive cash flow, forecasting £0.6-0.8bn this year.
- The company's debt remains high, and the dividend has yet to be reinstated, with management likely prioritizing financial health.
- The current valuation of the company is seen as fair, but the stock remains vulnerable to any sudden downturn in civil aviation demand.
Storied British aeronautical engineer Rolls-Royce ( OTCPK:RYCEF ) (RYCEY) now looks to be emerging from a challenging few years.
The share price has performed strongly in recent months. I now see it as fairly valued and so assign the company a "hold" rating.
I last covered the company in 2021's sell note Rolls-Royce: Its Ongoing Challenges Remain. At that point, with travel demand still severely depressed, cash burn remained a key concern for me. In the years since, travel demand has returned and the company became free cash flow positive once more. The shares have moved up 29% since that article.
Post-Pandemic Revival
The pandemic was a disaster for the company. Overnight slumps in civil aviation demand that lasted for years meant that engine sales and servicing of installed engines became much less in demand.
The rest of the business actually ticked over pretty well during those years, but civil aviation is such a core part of Rolls' business that that alone was a disaster. The company cancelled its dividend, issued a dilutive rights issue and took on debt, to boost its liquidity.
It also undertook a cost-cutting programme and another has been launched this year with the arrival of a new chief executive.
The effects are still being felt: civil aviation demand at Rolls has still not fully returned to 2019 levels (long term service agreement large engine flying hours are on track for 80-90% of pre-pandemic levels this year), the dividend remains cancelled, the share count has ballooned and parts of the business have been sold off with the proceeds partly used to reduce debt. But from a long-term perspective, the steps taken over the past few years arguably put the company in better shape for future.
But the company has returned to positive cash flow, forecasting £0.6-0.8bn this year. Given the pandemic-era cash bleed, that is good news. Underlying operating profit guidance for the year is £0.8-1.0bn.
Compare that to 2021 and 2020, when cash flow was -£4.1bn and -£1.4bn and underlying operating profit was £0.4bn and -£2bn.
Improving Balance Sheet
Last year's net debt showed a welcome sharp reduction.
But by historical standards at the company, debt remains high. Interest payments were a £352m hit to cash flow last year.
Along the way, the company disposed of ITP Aero and used the proceeds from that sale partly to pay down debt. Nonetheless, the company's debt remains a concern to me and certainly a drag on profitability.
Uncertain Dividend Prospects
Before the pandemic, one of the attractions of Rolls-Royce for some of its many retail shareholders was the dividend. However, that has yet to come back.
The company signed some loan agreements which stopped it paying dividends for a period (not that it was in a position to do so anyway) but as I understand it, those conditions have now expired and the company could pay dividends if it meets certain criteria (presuming the loans are still in place, which is unclear to me).
In reality I do not expect a dividend any time soon. The company has not yet become consistently profitable again and I think dividends are probably lower down management priorities than restoring rounded financial health. On top of that, dilution during the pandemic meant that the company's share count ballooned, from 1.9bn in 2019 to 8.3bn in 2022.
On the basis of that dilution alone, no matter how good business performance may be, I expect any eventual restoration of the dividend to be at a much lower level than pre-pandemic. The Rolls-Royce dividend history is of little use in predicting likely future payout levels, in my view.
Fairly Valued
There is clearly a recovery story going on at Rolls-Royce. The share price reflects that. It has moved up 88% over the past year.
That is good news for the shareholders (which included me at one point during that timeframe). But the stock is still at less than half of its pre-pandemic level, so over the long term it has still been a disappointing performer.
The current market capitalisation is £13bn. As a valuation, I think the share price is fair and perhaps even a bit optimistic.
After all, even long before the pandemic, Rolls-Royce often struggled to make a profit.
Lots of reasons have come and gone over the years, the pandemic just being the latest. But as I think the above chart shows, this is not a company that has favourable economics.
On a free cash flow basis, performance has been smoother but still remains far from compelling in my view.
Even picking the single best year for free cash flow over the past decade (2019), the current share price is around 15 times that level. That already looks like a fair valuation at best. Looking at the totality of the past decade, the current valuation looks unattractive.
I bought beneath £1 and I think that valuation would be attractive today. But the current valuation is not attractive to me, as the possible upside is already priced in but I am not confident the risks are properly reflected.
Risks
It is easy to look at the cash flow chart and discount 2020 and 2021 as exceptional. But one of the risks Rolls faces is that its business, although it has power systems and defence divisions too, remains highly vulnerable to any sudden, sustained downturn in civil aviation demand.
But such downturns happen - a decade or so ago it was the Icelandic volcano shutting down European airspace, a decade before that it was the 2001 terrorist attacks, a decade before that it was the Gulf War, and so on. We may not know what they are, but it seems foolish to expect no equivalent interruptions in future. That risk is significant for Rolls-Royce, in my view. Competitors like GE ( GE ) have more diversified income streams.
I think the current valuation can be justified as fair on the basis that Rolls has a solid position in an industry with few competitors and high barriers to entry, alongside a large installed customer base. But in the absence of markedly improved business performance I see no reason for the shares to move up from around their current level.
For further details see:
Rolls-Royce: No Obvious Upside From Here (Rating Upgrade)