The possibility of £6 Rolls-Royce (LSE:RR.) shares was aired today after a City bank highlighted much more “low-hanging fruit” for the recovering engines giant to aim for.
UBS’ base case is for shares to reach 350p, an increase of 175% on its previous target of 200p and more than double where Rolls stood before July’s big upgrade to guidance.
In its upside scenario, where Rolls delivers 2026 margins on a par with industry rival Safran SA (EURONEXT:SAF), UBS sees fair value at 600p. Noting that the risks and rewards are high, the downside scenario is 100p if the recent improvements prove to be unsustainable.
The bullish note today helped to put Rolls back among the biggest FTSE 100 risers, with the widely held stock peaking at 207.3p and reaching midday 3.8p higher at 205.6p. The shares were 80p after August 2022’s interim results.
This year’s half-year figures showed operating profits of £673 million on revenues of £6.95 billion, amid the early stages of the transformation under Tufan Erginbilgic. The underlying operating margin of 9.7% compared with 2.4% the year before.
The company expects an operating profit in 2023 between £1.2 billion and £1.4 billion, with free cash flow in the range of £900 million and £1 billion. However, UBS thinks this guidance still looks conservative given the strength of first-half results and historic seasonality patterns.
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It estimates that Rolls could achieve £2 billion of free cash flow as soon as 2024, potentially rising to £2.8 billion in 2026. The analysis points to favourable recent trends where Rolls may already be generating around $380 per flying hour on average against $300 in 2019.
Exposure to China’s economy is a risk, but UBS’ review of aircraft utilisation patterns over the first half currently suggests an upside risk to flying hours in the second half.
Only 78% of Rolls-Royce engines are currently flying at an average nine hours a day versus 10 before Covid. Chinese international flight volumes are still only 50% of 2019 levels, but with the potential to be 85% by year end.
UBS forecasts 16.5 million engine flying hours in 2024, some 8.5% ahead of consensus. Its calculations also look for civil aerospace margins to peak at 15% by the end of the decade, still below peers at 20%, with margins in power systems increasing to 12%, and defence to 14%.
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It expects sentiment to improve in the run-up to 28 November, when Erginbilgic reveals the outcome of a strategy review along with medium-term goals for the business.
The bank added: “A new CEO combined with a strong and under-appreciated market tailwind coming from China is likely to drive continued upside throughout 2023.”
Among other City firms, Bank of America recently increased its price target from 190p to 260p. It sees the potential for a return of dividend payments in the 2024 financial year as the balance sheet has become less of a concern for investors.
For the time being, however, Rolls will need to focus on returning to an investment grade credit rating before it can consider shareholder distributions.
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