Rolls’ shares are down 32% YTD, and the stock is now a consensus hold. This has created an interesting opportunity, and we initiate at OW for the following reasons:
(i) Civil value case still intact: Our positive view on the civil cycle means Rolls can continue to grow its main business. Growth spurts temporarily depress cash flow and margins, but we expect growth to eventually decelerate and the installed engine base to get sufficiently big as to make new engine deliveries less dilutive on aftermarket, resulting in improved margins and cash flow. Our DCF-based bull case price target of 1310p captures the embedded or back-end loaded value of the installed base and implies 55% upside.
(ii) Prudent capital structure a strength and an opportunity: Rolls’ net cash position supports further growth investments in civil and should allow it to successfully navigate further volatility in the shorter cycle businesses. It also implies scope for materially increased shareholder returns. While this may be unlikely in the near term given an uncertain macro environment, we view it as an optionality that is best captured in our bull case valuation.
(iii) Expectations materially rebased – scope for a rerating: Earnings have been cut by around 16% this year, and a small decline in profitability next year relative to this is now in the price. Consensus may even be coming out on the low side for 2016, in our view, and we are 5% ahead. With Rolls' shares having entirely given up their premium rating versus the market, we think delivery in-line with (or even ahead) of expectations from here can catalyse a rerating to our 1040p PT, which offers 23% upside.
Where could we be wrong? Risks to our investment case are: (i) an early end to the current civil aerospace cycle, though Rolls could be viewed as somewhat hedged in that while growth would slow, near-term margins and cash conversion would improve; (ii) a deeper slowdown in the shorter cycle businesses than we currently anticipate, as explored in our bear case; and (iii) any unexpected ramifications from the SFO investigation into Rolls, which is ongoing.