June 15, 2018 / 12:04 PM / 5 months ago

Breakingviews - Rolls-Royce investors wisely keep the seat belt on

The Rolls-Royce Trent 1000 engine powers the Boeing 787 Dreamliner, Image courtesy of the company

LONDON (Reuters Breakingviews) - Rolls-Royce investors are keeping their seat belt fastened despite the promise of an increasingly smooth journey. The British plane engine-maker aims to generate 1 pound of free cash flow per share over the mid-term, quadruple this year’s estimate. Despite the bullish new target, shareholders don’t look to be pricing it in fully. A distant horizon and history of one-off costs suggest why.

If “mid-term” means “in five years’ time” – at the shorter end of company guidance on Friday - Rolls-Royce’s valuation doesn’t look excessively generous even after a 9 percent bump in its share price on June 15. Assume the company can generate the 1.9 billion pounds of free cash flow it says it can, by end-2023. On a typical free cash flow yield for the sector of 6 percent, that would imply its shares should be worth over 16 pounds. Discounted back at Rolls-Royce’s 8.3 percent cost of capital as estimated by UBS, the shares would fetch over 11 pounds, tangibly above their current 959 pence.

Warren East has disclosed the rationale for the cash bonanza. The Rolls chief executive expects a big boost from reducing the loss the company makes when it sells engines to airlines, from 1.6 million pounds today to 400,000 pounds by 2022. Buying parts from Mexico rather than Spain and negotiating better buying terms from suppliers reduce the overall cost of producing engines. Meanwhile, an extra 2000 units by 2022 means more flying hours – which is when Rolls-Royce claws back the initial loss on the engine sale. Lowering the cost of so-called shop visits, or plane maintenance, will also help.

Investors may buy all this, but think the slightly nebulous timeline could slip a bit. They are also probably wary of one-off costs. The company itself pointed to risks inherent to the business, such as expensive problems that have bedevilled its Trent 1000 engine model.

If East wants to make his shareholders more bullish, he could divert some of the cash pile into dividends. Rolls-Royce cut its dividend payout in 2016. One way to make his share price rise further would be to display his confidence in his latest cash predictions.

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