On Friday, Rolls-Royce confirmed their prior guidance to reach (and possibly exceed) GBP 1 bn of free cash flow in 2020. The company forecasts GBP 450 m in 2018 (they made GBP 270 m in 2017). On top of that, they announced that it is their “mid-term ambition for free cash flow per share to exceed GBP 1”. This translates into GBP 1.9 bn. Warren East, CEO of Rolls-Royce, has shifted investor attention from profits to cash flow given accounting changes and increasing cash inflows from engine maintenance contracts.
To reach these goals a lot has to be done.
This includes another restructuring program over the next two years targeting GBP 400 m in cost savings while laying of 4,500 employees.
Moreover, quality issues with the company’s in-service engines continue to weigh on Rolls-Royce’s profitability. In Friday’s press release the company states that “At the time of our FY17 results in March we had anticipated that the cash costs associated with in-service issues on both the Trent 1000 and 900 would broadly double from the £170m incurred in 2017. Our current assessment is that the further issues encountered with Trent 1000 since our 7 March announcement could lead to combined additional 2018 cash costs of around £100m. We have, however, successfully enacted a number of short-term discretionary cost mitigation actions separate to, and outside of, the proposed restructuring plan, which we expect to offset these incremental costs. As such our FY18 free cash flow guidance remains unchanged at around £450m + /- £100m.”
From my perspective, this statement implies a hidden earnings revision. Nevertheless, market participants’ attention was focused on long term cash flow targets. The share price reacted favorably to Friday’s news flow.
Given the uncertainty surrounding the “mid-term” target to achieve GBP 1 per share in free cash flow, I want to be rewarded with a return of at least 25% per annum. I assume that Rolls-Royce will be able to reach the one pound per share target in 2022 or two years after reaching the first target of GBN 1 bn+ in free cash.
A 5% free cash flow yield for a company with recurring and growing cash generation seems to be an appropriate valuation. Consequently, Rolls-Royce could be worth GBP 20 per share in 2022. Discounting this valuation back to the present at my required rate of return for this investment, I come to the conclusion that the current price is 17% higher than the company’s intrinsic value.
Therefore, on Friday I sold my investment at 970 pence a share generating a total profit of 23.2% and an IRR of 8.1% over a holding period of almost three years. I might reinvest at a later point in time in case an investment in Rolls-Royce is becoming attractive again.
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