Are Rolls-Royce shares ‘abnormally cheap’?

Rolls-Royce (LSE:RR) shares have rewarded investors over the past six months, with shares almost doubling.

But this is only part of the story. At FTSE 100 The tech giant has shown considerable volatility since the start of the pandemic. In the midst of different situations, sales of business units and new companies, the market is actually struggling to value the company.

So what’s next for Rolls?

Cheap is not normal

Swiss bank UBS updated Rolls-Royce last week to ‘buy’ from ‘neutral’. The Zurich-headquartered firm nearly doubled its price target to 200p from 105p and said Rolls shares “abnormally cheap“.

“Despite a more than 40% move in share price since Q4 results Rolls is still trading almost 2pts below historical results on circa 9% consensus 2024 estimated free cash flow“, the bank said.

UBS highlighted China’s reopening as a key reason for optimism about the direction of share prices. He said the return of China – where wide-body aircraft using Rolls engines are flown on domestic flights – was “an underappreciated catalyst that can bring valuations back in line with historical norms“.

The bank stated that 51% of wide body traffic started or ended in Asia in 2019. China, UBS said, accounted for 40% of the reduction in absolute wide body traffic in 2022 versus 2019.

A wealth of catalysts

Figures released in February highlighted that China’s civil aviation is making a comeback, with a 34.8% year-on-year jump in January. The number of passengers in January recovered to 74.5% of the same period in 2019, according to the Civil Aviation Administration of China.

Air China said passenger turnover rose by 62.2% year in January, or 121.6% per month.

But not only China. Airlines around the world are betting on a strong recovery in civil aviation. Lufthansa and Indian water are among those expecting an increase in income this year.

This is significant, as civil aviation accounted for 45% of Rolls’ revenue last year. The engineering giant makes money from engine performance hours and servicing, not just front unit sales.

Geopolitical tensions have pushed up global defense spending which, in the medium term, should be a positive catalyst for Rolls’ defense segment. Orders for power systems – the third of the three main business segments – will increase by 29% to £4.3bn in 2022.

Debt is always a problem for some investors. However, down at £3.3bn – smaller than this time last year – the debt burden looks more sustainable, although I appreciate repayments will drag on profitability.

And as UBS highlighted, supply chain risks could impact cash flow in 2023.We believe that management’s 2023 cash flow guidance is a key risk; miss or downgrade here will reset the uplift reputation reached so far“, he said.

For me, there are many positive catalysts here. There is a lot of evidence that stock prices can continue to rise. That’s why I bought another one.