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Could Rolls-Royce shares be the top pick for 2023?

Young female couple boarding their plane at the airport to go on holiday.

Rolls-Royce shares are down 20% over the past 12 months, despite a recent rally.

But the challenges faced by the aerospace and defence giant are even more pronounced when we look further back. The stock is down a whopping 58% over three years.

However, the past three years aren’t indicative of future performance. Personally, I’m bullish on this FTSE 100 stalwart. In fact, it could be my top pick for growth in 2023. Let me explain why.

Valuation

In the summer of 2022, Morgan Stanley said Rolls-Royce shares were “woefully mispriced”. 

The bank said the earnings recovery was “much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery”.

At the time, the shares were trading for 95p. Fast forward seven months, and today they’re priced at 96p.

So have investors just missed an opportunity? Or was the big American bank wrong?

Well, using a host of valuation metrics, Rolls-Royce shares still appear undervalued compared to peers in the same industries.

For example, Rolls has an EV-to-sales ratio of 1.1 versus a sector average of 1.6 and a price-to-cash flow ratio of 7.4 versus a sector average of 15.3.

A more telling valuation metrics is the discounted cash flow model (DCF). A DCF with an exit at 10 years suggests Rolls is undervalued by 49.6%, while a DCF with an exit at five years suggests the firm is overvalued by 5.8%.

As a long-term investor, I’m focusing on the 10-year calculation. The analysts who produced this DCF infer a share price range for 10-year exit of 88.8p to 238p. 

Reasons for optimism

The pandemic engendered a difficult period for Rolls. The company took on an additional £2bn in government-backed debt which has recently been paid off through the sale of business units.

The primary issue was that engine-flying hours — the company’s main revenue generator — fell substantially as Covid hit.

But, finally, we’re seeing the conditions improve. The group recently announced that large Engine Flying Hours (EFHs) are around 65% of pre-pandemic levels in the four months to the end of October. And now China’s reopening should provide a major boost as long-haul flying hours have lagged.

Rolls also received a multi-billion dollar uplift in December as it was announced that the US awarded the contract for its Future Long-Range Assault Aircraft, FLRAA, to Textron‘s V-280 Valor project.

Rolls-Royce will deliver two AE 1107F engines to power each V-280 Valor, bringing the total anticipated demand to 5,000 engines throughout the project’s lifecycle.

We estimate that the total value of the V-280 program for Rolls-Royce could reach up to $5-6bn in production and $6-7bn in services assuming 5,000 installed engines are delivered“.

Naturally, I’m very aware of the sizeable debt burden. Rolls still has £4bn in debt obligations — all on fixed interest rate terms — maturing between 2024 and 2028. However, the firm is well on the way to recovery, and I’d buy more Rolls shares today despite a considerable holding already.

The post Could Rolls-Royce shares be the top pick for 2023? appeared first on The Motley Fool UK.

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James Fox has positions in Rolls-Royce Plc. 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.