Source of opportunity
Rolls-Royce has historically been viewed as a Civil Aerospace company and valued on earnings. In reality, half of 2014 sales were from other business lines, and we believe the accounting policies mean earnings are a poor indicator of economic value. Following a 48% fall in the share price since the beginning of 2014 and profit warnings in three major end markets, we believe the current valuation fails to reflect Rolls-Royce’s cash flow improvement, despite weak earnings growth. We favour a cash flow-based valuation method, seeing almost 50% upside to our new, 12m 966p PT. We remove the Not Rated designation from the shares and reinstate at Buy.
Catalyst
Rolls-Royce will release a 3Q IMS on November 12 and will host an Investor Day on November 24 to update investors on the ongoing operating review. We believe focus on the medium-term outlook at this update could be
supportive for the shares.
Valuation
We value Rolls-Royce on 10.2x 2017E EV/DACF; this target multiple is based on our 2017E CROCI forecast of 15.5% and assumes a 1:1 relationship between EV/GCI and CROCI/WACC. This compares to the average target multiple of 11.4x for the sector (12.3x for Safran). In our view, a cash flow and returns-based valuation method captures the underlying drivers of economic value. We expect DACF (debt-adjusted cash flow) growth to outpace earnings; from 2015-18, we forecast an EBIT CAGR of 1% but improving cash conversion should result in a DACF CAGR of 17%.
Key risks
Risks to our view and forecasts include: 1) FX; 2) pressure in defence spending in the core and export markets (where visibility is lower than in other businesses); 3) continued declines in sanctioned offshore capex spend; 4) programme risks, such as at Trent XWB and Trent 1000.