Jet engine specialist Rolls-Royce Holdings (LSE: RR) has edged ahead of the market over the last 12 months, gaining 19%, versus a 15% rise for the FTSE 100. But the Rolls-Royce share price is still a long way below its pre-Covid levels.
The good news is that things are improving. Rolls reported a profit for the first half of 2021. Management says the group is on track to start generating surplus cash during the second half of the year. With the stock hovering around 110p, I’ve been wondering if it’s the right time to buy.
Getting back to normal?
It’s probably a bit soon to suggest Rolls-Royce is back to normal. But I’m sure chief executive Warren East has now put the foundations into place for a successful recovery.
Businesses being targeted for disposal should raise £2bn to help repay debt. Cost savings are expected to total more than £1bn by the end of this year. In the meantime, the group has access to up to €7.5bn in cash, if needed.
Of course, companies can’t simply cut their way to growth. Rolls is still investing in developing its existing engines and in zero emission technology for the future.
Operationally, the company’s defence business has delivered stable profits throughout the pandemic. In civil aerospace, which has been hit hard by travel restrictions, the company says private jet and domestic flying activity has already returned to 2019 levels.
International travel is lagging behind, but Rolls says that, in total, large engine flying hours reached 43% of 2019 levels during the first half of the year.
How high can the Rolls-Royce share price go?
I expect the global aviation market to gradually return to normal over the next two years. Rolls-Royce’s profits should follow. Broker forecasts suggest the group will report a pre-tax profit of £373m in 2021. Analysts expect this figure to rise to £591m in 2022 and to £807m in 2023.
With Rolls-Royce shares trading at around 110p, as I write, these price the stock on 22 times 2022 forecast earnings, falling to a multiple of 15 times earnings in 2023.
I think there’s still some room for growth, on a medium-term view. If I bought Rolls-Royce shares today, I’d probably hope for a price of 150p, over time.
Unfortunately, I think 175p may be a little too high. Although that’s still a long way below the 230p share price seen before the pandemic, we have to remember that Rolls-Royce has issued a lot of new shares over the last year.
Issuing new share causes dilution — future profits must be divided among a larger number of shares. This means that future earnings per share are likely to be lower than in the past, even if profits recover. Lower earnings per share mean a lower share price, based on the company’s historic valuation levels.
Would I buy Rolls-Royce shares at today’s price? Possibly. I think it’s a good business with valuable technology and a big share of the long-haul aviation market. It’s a stock I’d be happy to own.