Is Rolls-Royce a bargain?

Rolls-Royce (LSE: RR) stock has rallied a lot recently. 

Due to the vaccine candidate news, RR has rallied almost 30% in the last one month according to Hargreaves Lansdown. In the calculations, I think the broker factored in the recent rights issue. 

Given the rally, is the stock still a bargain? Here’s what I think.

Worst behind Rolls-Royce?

I think the worst is probably behind the company as far as the pandemic is concerned. This is because of Rolls-Royce’s fund raising in October and recent positive Covid-19 vaccine news. Thanks to RR’s fund raise, many analysts think the company has enough money to make it out of the pandemic in most scenarios. 

If a vaccine is approved and distributed smartly, I also think the worst case scenario — the pandemic lasting longer than Rolls-Royce has money for — is unlikely. 

Free cash flow shortfall this year

Before Covid-19, Rolls-Royce had a trend of rising free cash flow (FCF). RR’s underlying group FCF, for instance, was £568m in 2018, and £873m in 2019. 

As late as 28 February 2020, RR management expected at least £1bn in FCF for 2020 when excluding any material impact from Covid-19. Before Covid-19, management also said they were targeting over £1.9bn FCF in the mid-term.

Of course, the pandemic occurred, and now things are completely different. 

Rather than generate at least £1bn in FCF, the company said in October that it could have cash outflows of £4bn this year. 

To compensate for the outflows, RR has had to issue additional billions in debt and RR’s share count is now much higher due to a recent rights issue. The company may also have to sell some assets that very likely will make achieving the mid-term FCF target harder.

While Covid-19 has damaged the company, I nevertheless think the long term still looks pretty good if management executes. To me, Rolls-Royce has a great business. The company is one of the leaders in its field. Given the difficulty of jet engine R&D, RR has few competitors. 

If RR executes, I think management could pay off the additional debt it took in a fair amount of time. 

Although I don’t think RR has anywhere near the upside it did before on a per share basis, due to the increase in share count, I still think there is potential for the stock to be higher in the long term. 

What the market thinks

At the end of the day, I think the question of whether Rolls-Royce is still a bargain depends on how the market views the stock. 

The market takes an optimistic long-term view with some stocks. For many tech stocks nowadays, valuations are often higher as the market is willing to give credit before the company has achieved it. 

With some other stocks, the market is much harsher in terms of expectations. For those stocks, investors want to see attractive profits or profit growth before they award any meaningfully higher valuations. 

If the market judges RR on its near-term financials, I don’t think the stock is much of a bargain anymore. Given RR’s market cap of £8.62bn, according to Hargreaves Lansdown, and management’s target of FCF of £750m in 2022, the stock isn’t really that cheap versus some other stocks. 

If the market judges RR on its long-term financials, however, I think it is a bargain and I’d still consider buying the stock.