Rolls-Royce (LSE: RR) has had a long and (at times) turbulent history, including being taken into state ownership in 1971. However, it was floated on the stock market at 170p a share in 1987 and long-term investors have enjoyed an excellent return, despite some ups and downs along the way.
The shares reached an all-time high of well over 1,200p four years ago but lost more than half their value over the next two years due to a string of profit warnings. A recovery to close at 1,000p by November last year has stalled and the shares are currently trading not much above 800p.
Rolls-Royce isn’t the only FTSE 100 stock with turnaround potential in the market today, but I believe its quality management team can deliver and unleash the latent upside of over 50% to the stock’s previous high.
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Turnaround
Warren East, the former boss of British tech champion ARM, took over as chief executive of Rolls-Royce in 2015. The company was in the midst of battling headwinds from the collapse of the oil price, which was hurting its Marine division, and managing a major transition in its Aerospace business from mature engines to next-generation, more fuel-efficient ones.
However, East identified a need for a wholesale transformation of the group’s management, processes and culture. He’s already achieved a great deal but the restructuring is still in process. The company announced on 17 January that it’s embarking on a further simplification of the group, including a potential sale of the commercial arm of its Marine division and a reduction from five operating businesses to three core units based around Civil Aerospace, Defence and Power Systems.
The company has achieved the target East set in 2015 of a fixed cost reduction rate of over £200m by the end of 2017 and the new measures will strip further costs and complexity out of the business. CFO Stephen Daintith commented: “We are taking decisive action now in order to secure and enhance the long-term benefit of the cash flows that will be generated over the coming years.”
Free cash flow set to soar
The company hasn’t put a number on the future cash flow benefits. It said it’s still in the process of defining the restructuring but will give further details when it announces its annual results on 7 March and a fuller discussion at a capital markets event later this year.
Whatever the number turns out to be, I reckon it should support or enhance the analyst consensus free cash flow (FCF) estimates, currently published on Rolls-Royce’s website. These figures, shown in the table below, were compiled on 8 January — i.e. before the 17 January announcement of the further simplification of the business.
| FCF (£m) | |
| 2017 | 129 |
| 2018 | 405 |
| 2019 | 722 |
| 2020 | 1,002 |
The company’s previous peak FCF — in the year the shares made their all-time high of over 1,200p — was £781m. Even without any upgrades to the projections in the table, Rolls-Royce would be well on its way towards that figure next year, before soaring past it and breaking through the £1bn level in 2020.
As such, the shares have potential upside of in excess of 50% on a two-to-three year view, if management successfully executes its plans and the market rates the company on the kind of price-to-FCF multiple it did in the past. The risk/reward balance looks favourable to me and I rate the stock a ‘buy’.
