Why this analyst rates Rolls-Royce and Next shares a buy

A City analyst ‘more constructive on UK equities’ has spelled out their rationale for buying two of Britain’s best-known companies. They also predict when Rolls may resume dividend payments.

Rolls-Royce Holdings (LSE:RR.) and Next (LSE:NXT) shares have been backed to continue their robust starts to 2023 after a major City bank switched to “buy” recommendations on both FTSE 100 stocks.

Bank of America now sees the potential for Rolls to reach 175p, which compares with this afternoon’s 146.4p after a surge of more than a third since Thursday’s annual results.

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It said client interest in Rolls has grown materially due to the turnaround potential at the engines giant, which has been led by Tufan Erginbilgic since 1 January and is enjoying the cyclical benefits of the strong China and international travel reopening.

Next, meanwhile, has been upgraded to a target price of 7,800p as part of a more positive stance on the retail sector as the risks of a consumer hard landing moderate and key commodity price begin to normalise.

The bank said: “We do not contest that discretionary spending is likely to remain under pressure in 2023. However, we think this is better anticipated than at the time of our last sector update in October.

“Fundamental green shoots are emerging, positioning is low, and valuation is attractive. This is making us more constructive on UK equities - and we favour discretionary over food.”

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Its top picks in the sector are JD Sports Fashion (LSE:JD.), ASOS (LSE:ASC) and B&M European Value Retail SA (LSE:BME) with potential upsides at the time of the report of 31%, 104% and 21% respectively.

On Next, its analysts believe the high street bellwether represents a compelling value opportunity in omni-channel retail.

They wrote: “Highly effective in driving synergies across online and offline channels, Next has successfully shifted from an offline and directory retailer to an omni-channel leader.

“Despite this, it still trades at a 40% valuation discount to omni-channel peers Inditex and Hennes & Mauritz (OMX:HM B). We think this gap should close.”

On Rolls, the bank believes the “bear thesis” has now played out and that there’s potential for over £1 billion of free cash flow by 2024 as engine flight hours continue to recover. Currency hedges remain a significant headwind versus peers but these will unwind strongly from 2025.

Last week’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.

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This year’s figure is seen in the range of £600 million and £800 million as the reopening of China’s economy means Rolls expects large engine flying hours at 80%-90% of their 2019 pre-Covid level, compared with 65% in 2022.

The new CEO also highlighted his focus on improving the cost base and efficiency to close the performance gap versus peers. After multiple restructuring programmes since 2015, however, Bank of America questioned how easy this cost-cutting will be without more structural change at the group.

Its report on the engines giant highlighted Rolls as the cheapest of Europe’s aerospace and defence stocks on a free cash flow yield basis, although high levels of debt make it the most expensive on a multiple of enterprise value to earnings.

Net debt fell to £3.3 billion last year from £5.2 billion in 2021, and the bank views balance sheet concerns as backward looking.

It adds: “Given the improved cash performance, and recovering end market outlook now we see a clearer path to deleverage the balance sheet and see Rolls reinstating dividends in 2024 with about 1p a share.”

Among other City analysts, US bank Jefferies said yesterday it now sees Rolls shares as having the potential to reach 170p compared with 125p previously.