Rolls-Royce (LSE:RR) shares have rallied in recent weeks, pushing up 13% over one month and 49% over three months. The FTSE 100 stock’s volatility has been extraordinary, and this is highlighted by the fact that over a year Rolls is still down 18%.
But this is just the tip of the iceberg. The engineering giant has struggled since the start of the pandemic and has shed 55% of its market value over three years.
So is Rolls-Royce a diamond in the rough? Maybe I can double my money from here?
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Three tough years
The pandemic engendered a very tough period for Rolls as it makes a large proportion of its income from engine-flying hours. 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.
So clearly it’s still an issue. But the start of 2023 looks more promising, especially with China’s reopening.
But as civil aviation ground to a standstill in 2020, Rolls took on more debt. In fact, £2bn of government-backed debt was recently paid off, funded by the sale of business units. As result, Rolls is smaller today than it was three years ago.
Near-term upside
But performance appears to be improving. Rolls will likely benefit to the tune of 5,000 engine orders after the US awarded its Future Long-Range Assault Aircraft (FLRAA) to Textron‘s V-280 Valor project. Rolls-Royce provides two AE 1107F engines to power the V-280 Valor. This programme could be worth $5bn-$7bn, according to a forecast in Rolls’s 2021 annual report.
This has contributed to an improving order book across multiple business segments. New momentum in civil aviation could lead to new orders as demand for new engines comes online. In the first year of the pandemic, airlines mothballed more than 13,700 aircraft. A necessary move in the short term, but one that impacted long-term supply.
The firm has said there is no material benefit to its defence sector from the increasingly tense geopolitical environment. However, there may be a longer-term upside.
Valuation
Can Rolls-Royce double in value? At this moment, the business could still be undervalued by around 45%, according to a discounted cash flow (DCF) calculation with a 10-year exit. But, as is always the case with the DCF model, the challenge is forecasting the company’s cash flow over the coming years.
However, the calculation infers a share price range for 10-year exit of 88.8p-238p. The top end of this range would mean that I could more than double my money from the current position.
I’m already a shareholder in Rolls-Royce and I do see considerable potential for the share price to push upwards this year and beyond. The DCF model suggests it’s entirely plausible that I could double my money. And at 103p, I’m buying more Rolls-Royce stock. But I’m equally very aware of the impact of debt on the balance sheet, and how this could impact cash flow moving forward.
