Interactive Investor

Rolls-Royce price target adds thrust to rally

8th March 2023 14:54

by Graeme Evans from interactive investor

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New chief at the helm and a market tailwind from China is likely to drive continued upside for the FTSE 100 share through 2023.

Rolls-Royce factory 600

A £2 price target for an “abnormally cheap” Rolls-Royce (LSE:RR.) today gave added thrust to the engine giant’s stunning recent share price revival in the FTSE 100 index.

UBS believes the catalyst of a new chief executive and a strong and under-appreciated market tailwind coming from China is likely to drive continued upside throughout 2023.

Shares today rose another 4.7p to 157.9p and are now up by more than 45% since better-than-expected results on 23 February. However, the recent momentum hasn’t deterred UBS from a near doubling of its target price to 200p, a day after counterparts at Kepler Cheuvreux opted for a “buy“ recommendation and lifted their price target to 190p from 110p.

UBS’s new target is based on 30% increases in earnings forecasts, as well as improved confidence in execution and normalisation of long term working capital expectations.

The bank’s upside scenario sees fair value at 300p, but it warns the risks to its “buy” case are still material as a downside scenario sees a return for shares to 90p.

In particular, UBS warns that a miss or downgrade to management’s 2023 guidance for free cash flow of between £600 million and £800 million would result in a reset to the reputational uplift achieved so far.

Last month’s boost for Rolls-Royce shares came as it revealed £502 million of free cash flow, up from the City’s £64 million forecast and an outflow of £1.5 billion the previous year.

This year’s forecast is built around large engine flying hours at 80%-90% of their 2019 pre-Covid level, equivalent to a range of 12.2 million to 13.8 million flying hours.

UBS is optimistic about the recovery and models 16.4 million flying hours in 2024, which is  7% above 2019 levels and already above consensus estimates for 2025 of 14.8 million.

It points out that the widebody market is heavily skewed to Asia and especially China, with 51% of 2019 widebody traffic starting or ending on the continent.

The bank said: “Chinese weakness alone accounts for over 40% of the absolute widebody traffic reduction in 2022 vs 2019, so we see China's reopening as an important and under-appreciated catalyst that could bring valuations back into line with historical norms.”

Its base case uses a cost of equity of 14% against the rest of the industry where it uses only 10%, reflecting a large remaining discount for execution risks.

New boss Tufan Erginbilgic last month highlighted a renewed focus on improving the cost base and efficiency in order to close the performance gap versus peers.

More details are due later in the year, including the key points from a strategic review designed to focus investment on the most profitable opportunities.

These are still early days in the turnaround, however, with net debt of £3.3 billion meaning dividends remain suspended as Rolls focuses on restoring an investment grade credit rating.

Bank of America, which has a price target of 175p, also said recently that multiple restructurings since 2015 made further cost cuts harder without deeper change.

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