Is Rolls Royce worth 327p a share?

Analysts’ 12-month median estimate suggests that the British engineering company could see its share price hit 327p per share in 2020. But is Rolls Royce capable of rallying 16% over the next five months?

While the British engineering company certainly could see its share price trend higher, price action indicates that the stock is trending lower, with the stock down 28% since hitting 398p back on 8 June.

Rolls Royce was also dealt a major blow last month when credit ratings agency Fitch opted to down grade it to from ‘BBB+’ to ‘BBB-‘ given the company’s negative outlook for 2020.

The downgrade reflects weaker than previously expected cash flow generation leading to a greater spike in funds from operations gross leverage for FY20 and FY21 with leverage remaining outside our previous sensitivities into FY22.

The weaker cash flow generation is largely driven by Rolls-Royce expecting reduced profitability from its civil aerospace aftermarket and services, but is also exacerbated by the difficult market conditions experienced in its power systems division.

Fitch also expects that poor trading conditions will result in a working capital outflow for FY20 (as opposed to the positive impact we previously expected for the year), significantly impacting cash burn.

‘The negative outlook continues to reflect the uncertainties of a more extended coronavirus pandemic as well as the uncertain form and timing of a recovery for both aftermarket services and engine deliveries for Rolls Royce's civil aerospace division,’ Fitch said in a statement.

‘The group continues to face risks to the completion of its fixes to the Trent-1000 engine issues, which increases its business risk profile in the short term.’

Citigroup believes Rolls Royce shares could double in value in 2020

Last week, Citigroup analysts offered an highly optimistic outlook for Rolls Royce, with the US-based investment bank reiterating its ‘buy’ rating for the stock and issuing a target price of 564p – implying a potential upside of 100%.

However, based on the uphill battle ahead of Rolls Royce and the level of uncertainty among investors due a myriad of macroeconomic headwinds, chief among them the threat of a second wave of Covid-19 cases, such a meteoric rise appears unlikely.

It is also worth nothing that the stock has struggled to break above 398p since the Covid-19 crisis occurred. But if it were capable of breaking above that key resistance level this year it could push on to higher highs in the latter half of the year – though that is highly dependent on whether Europe is hit by a second wave of cases.

Rolls Royce spends £3 billion in H1 due to Covid-19

Another factor weighing heavily on the engineering company’s share price is that it spent £3 billion in cash over the first half of 2020 as a result of the ‘historic shock’ caused by Covid-19.

Rolls Royce is hoping that its performance over the second half of the year will go some way to offset the impact the viral outbreak has had on its business, with the company forecast to generate annual free cash outflow of £4 billion. Free cash flow in the six months to the end of June was hit by £1.1 billion less inflow from lower receipts linked to engine flying hours and lower engine deliveries.

‘The Covid-19 pandemic has created a historic shock in civil aviation which will take several years to recover,’ Rolls Royce CEO Warren East said. ‘We started this year with positive momentum and strong liquidity and acted swiftly to conserve cash and cut costs to protect Rolls-Royce during the pandemic.’

Rolls Royce is hoping its £4 billion of free cash outflow in 2020 will come from spending cuts and a recovery in commercial airlines now that lockdown restrictions are being eased by governments in Europe.

However, Russ Mould, investment director at AJ Bell, expressed serious concern about the health of Rolls Royce balance sheet.

‘Cash, the very lifeblood of any business, [is] draining away alarmingly in the first half of the year, he said. ’The numbers are stark and will do little to stem recent speculation that the company might need to issue shares or even offload a part of the group to generate cash.’

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