The Rolls-Royce (LSE: RR) share price crashed 23% last week. This has taken its fall since the start of the year to an eye-watering 83%. Closing on Friday at 113.6p, the Rolls-Royce share price is now at a level not seen for 17 years!
Investors have deserted the company in droves. But I believe we’re looking at an opportunity for bold contrarians to take advantage. It needs a particular strategy to make the most of the opportunity, but I’ll come back to that shortly.
The Rolls-Royce share price halved in less than six weeks
A share price doesn’t collapse as spectacularly as Rolls-Royce’s for no reason. The company released its 2019 results on 28 February. This was 12 days before the World Health Organisation declared the Covid-19 outbreak a pandemic.
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Management reported good momentum in the business through the second half of 2019. It said this “underpins our confidence for the year ahead.”
Its 2020 guidance was for a 15% increase in underlying operating profit, and at least £1bn free cash flow (FCF). The guidance excluded any material Covid-19 impact. But management remained confident in its mid-term target of £1.9bn+ FCF, equivalent to at least £1 per share.
The market warmed to the results, and pushed the shares up 5% on the day to over 635p. However, they were below 300p come a trading statement on 6 April.
With lockdowns and travel restrictions whacking its civil aerospace business, Rolls-Royce cancelled its 2019 final dividend and 2020 guidance. It also said it had taken a “precautionary decision” to draw down its existing revolving credit facility and secure an additional one.
The Rolls-Royce share price and rights issue
There’s an old City saying for when a company faces an outlook where it may have to ask its shareholders for additional funds: “Go early, and go big.” A significant number of companies did just this in the first couple of months of the pandemic. Arguably, Rolls-Royce could and should have.
Writing about the company at the end of August, I suggested buyers of the stock hold back some cash to participate in the event of a discount fundraising. The company announced its intention to do such a fundraising last Thursday. Subject to approval by shareholders at a meeting on 27 October, it intends to raise gross proceeds of approximately £2bn by way of a fully underwritten 10 for 3 rights issue at 32p a share.
For every three shares you buy in the market today at 113.6p, you’ll have the right to buy a further 10 for 32p. Therefore, your average buy price would be around 51p. This is what the market’s currently pricing the shares to trade at when the rights issue is complete and the new shares admitted to trading.
Why I’d buy Rolls-Royce today
The rights issue will strengthen Rolls-Royce’s balance sheet. This, and other steps it’s taking to improve liquidity, should see it through what management calls any “reasonable worst case” scenario.
The company is targeting FCF of at least £750m as early as 2022. According to my sums, based on the post-rights issue number of shares, this equates to 9p a share FCF. At the aforementioned average 51p buy price, the FCF yield is a highly attractive 17.6%.
Therefore, I’d buy Rolls-Royce today at the 113.6p share price, and hold enough cash back to take up the 10-for-3 rights issue at 32p a share.
