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Are Rolls-Royce shares ‘abnormally cheap’?

A front-view shot of a multi-ethnic family with two children walking down a city street on a cold December night.

Rolls-Royce (LSE:RR) shares have rewarded investors over the past six months, with the stock almost doubling in value.

But this is only part of the story. The FTSE 100 engineering giant has demonstrated considerable volatility since the start of the pandemic. Amid varying conditions, business unit sales and new enterprises, the market has essentially struggled to value the firm.

So what’s next for Rolls?

Abnormally cheap

Swiss bank UBS upgraded Rolls-Royce last week to ‘buy’ from ‘neutral’. The Zurich-headquartered corporation nearly doubled the price target to 200p from 105p and said the Rolls shares were “abnormally cheap“.

Even despite the more than 40% share price move since Q4 results Rolls still trades nearly 2pts below its historical yield at circa 9% consensus 2024 estimated free cash flow”, the bank said.

UBS highlighted China’s reopening as a major reason for its optimism on the direction of the share price. It said that China’s return — where wide-body aircrafts using Rolls engines are flown on domestic flights — was an “underappreciated catalyst that could bring valuations back into line with historical norms”.

The bank highlighted that 51% of wide-body traffic either started or ended in Asia in 2019. China, UBS says, accounted for 40% of the absolute wide-body traffic reduction in 2022 versus 2019.

A wealth of catalysts

Figures released in February highlighted that Chinese civil aviation was back, with a 34.8% year-on-year leap in January. Passenger numbers in January recovered to 74.5% of the same period in 2019, according to the Civil Aviation Administration of China.

Air China said its passenger turnover rose by 62.2% year on year in January, or 121.6% month on month. 

But it’s not just China. Airlines around the world are betting on a strong recovery in civil aviation. Lufthansa and Air India are among those expecting an earnings boost this year.

This is important, as civil aviation accounted for 45% of Rolls’ revenue over the past year. The engineering giant makes money from engine performance hours and servicing, not just the upfront unit sales.

Geopolitical tensions have pushed up global defence spending which, in the medium-long run, should be a positive catalyst for Rolls’ defensive segment. Orders for power systems — the third of the three main business segment — were up 29% to £4.3bn in 2022. 

Debt is certainly an issue for some investors. However, down at £3.3bn — substantially smaller than this time last year — the debt burden looks more sustainable, although I appreciate repayments will drag on profitability.

And as UBS highlighted, supply chain risks could impact cash flow in 2023. “We believe management’s 2023 cash flow guidance is a key risk; a miss or downgrade here would reset the reputational uplift achieved so far“, it said.

For me, there’s a wealth of positive catalysts here. There’s a lot of evidence that the share price could push further upwards. That’s why I’m buying more.

The post Are Rolls-Royce shares ‘abnormally cheap’? 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.