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Will the Rolls-Royce share price become a star performer?

A Rolls-Royce employee works on an engine

The Rolls-Royce (LSE: RR) share price is down 30% this year and City analysts seem to be queuing up to bash this FTSE 100 veteran.

There are obviously some risks out there. But many of the criticisms being aimed at Rolls sound short-sighted to me. Here, I want to explain why I’m bullish on Rolls-Royce and view the stock as a long-term buy.

The recovery is continuing

Airlines are seeing high levels of staff absence due to Covid. But this only serves to highlight the growing return to normal.

British Airways owner IAG expects to fly 85% of 2019 capacity this year. The airline’s longer flights, such as key US-UK routes, will often be powered by Rolls-Royce engines.

This story is being repeated all over the world. As flying hours recover, Rolls-Royce should see a steady increase in maintenance billing. I expect profits to soar, as the company benefits from more than $1bn in cost savings over the last two years.

This view is supported by broker forecasts. City analysts expect Rolls-Royce’s underlying operating profit to climb from £414m in 2021 to £1,147m in 2024. Net debt is expected to fall by £1.5bn over the same period.

It seems that if things go to plan, Rolls is about to become a cash machine.

What about the energy transition?

Rolls’ existing technology has one big problem. It requires airlines to burn vast amounts of oil-based fuels. Governments, airlines, and suppliers like Rolls-Royce all want to cut the carbon footprint of air travel.

To achieve this, most experts agree that new technology will be required. Under outgoing CEO Warren East, Rolls has increased its commitment to technology, such as electric power, greener fuels and miniature nuclear reactors.

I see this as a good thing. As a world-leading industrial group, I reckon Rolls-Royce should be investing in new technology. However, some City analysts disagree.

US bank JP Morgan downgraded Rolls-Royce shares to ‘sell’ last week, saying the company’s focus on new technology suggested it might lack confidence in its core civil aviation business.

This seems very short-sighted to me. But I can see the risks. Rolls-Royce could end up investing heavily in new technology, but failing to find any commercial solutions. In this scenario, the company could lose a lot of money and suffer a loss of focus.

Will new CEO lift Rolls-Royce share price?

East admitted he “didn’t know quite how bad it was” when he became Rolls-Royce chief executive in 2015. But I think he has put the foundations in place for a long-term recovery.

Now with the worst of the pandemic behind the company, East will step down later this year. The board hasn’t appointed a new chief executive yet. But press reports suggest the view among big investors is that they want someone who will continue following his strategy.

I agree. As I’ve explained, I reckon Rolls is well-positioned to deliver a strong recovery in profits over the next few years. Looking further ahead, the company has the potential to play a big part in the decarbonisation of air transport. Changing strategy now could seriously slow the group’s progress.

Right now, I don’t think these opportunities are reflected by the Rolls-Royce share price. The market appears to be taking a cautious view at the moment and focusing on potential problems.

There are certainly risks, including disruption relating to high oil prices and China’s continuing lockdown. And I can’t be sure of catching the bottom but, on a long-term view, I think Rolls-Royce shares are starting to look pretty cheap.

Rolls-Royce is cheaper than in 2019

I believe the pandemic is now mostly behind us and that air travel will gradually return to normal. If I didn’t think this, I wouldn’t consider buying Rolls-Royce shares.

On that basis, I think it makes sense to compare the company’s valuation with the end of 2019. So to do this, I’m going to use Rolls’ enterprise value — its market-cap plus net debt.

At the end of 2019, Rolls-Royce had an enterprise value of £15.9bn. Today, that figure is £12.7bn. This tells me that the market is valuing this business 20% lower than at the end of 2019.

Of course, Rolls-Royce’s profits in 2022 are expected to be lower than in 2019. But that’s not expected to last. Broker forecasts suggest the group’s operating profit in 2023 could be 15% above 2019 levels.

A lower P/E?

Comparing past and present valuations can be useful. But what if Roll-Royce’s share price was just too high in 2019? Perhaps the shares are more correctly valued now.

To find out more, I’ve taken a look at the stock’s forecast price/earnings ratios. Rolls is currently trading on 20 times 2022 forecast earnings. That seems high enough, on a short-term view.

However, when I look further ahead, I can see some potential value. Rolls’ forecast P/E drops to 14 for 2023, and to just 10x earnings in 2024.

Rolls-Royce shares: my decision

The events of the last two years have taught us that forecasts are always uncertain. But, in general, I think it’s reasonable to assume that air travel will return to some kind of normality over the next 18 months.

I also think that when Rolls-Royce appoints a new chief executive, he or she may be able to reassure investors that the company will be able to navigate the transition from oil fuels to sustainable energy, without losing focus on its core business.

I don’t know what will happen to the Rolls-Royce share price over the next few months. But on a long-term view, my feeling is that the stock offers good value and has growth potential from current levels.

I’d be happy to buy Rolls-Royce shares for my portfolio today and tuck them away until 2030. I think there’s a good chance I’d do well from the investment over this period.

The post Will the Rolls-Royce share price become a star performer? appeared first on The Motley Fool UK.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.