Who's tipping Rolls-Royce to rally again?

Last year, Rolls-Royce was in a mess. After a string of profits warnings, its share price had halved and the aerospace engineer cut its dividend for the first time in a quarter of a century.

However, an accident-free set of results early in 2016 marked a bottom, and a recovery got underway.

We backed Rolls again in February Share of the week: An icon revived. Only days after the company had unveiled its biggest ever annual loss of £4.6 billion, Goldman Sachs upgraded the shares from 'neutral' to 'buy' and the price target from 743p to 1,030p. Rolls shares subsequently surged by over 14% to 761p.

"Goldman's backing was enough to thrust Rolls shares above the three-year downtrend,” we said, “which could provide a launchpad for further gains."

It did, and Rolls is currently just a short stroll from 900p and a two-year high.

Now, analysts at UBS have taken another look, and upgraded their price objective by 17% to 980p. That implies potential upside of at least 10% from here.

"We estimate RR's large engine installed fleet justifies about 46% of Rolls Royce market cap [£16.3 billion], providing material valuation support," writes the broker.

"Our base case suggests about 400p of fair value for the commercial engines installed base. In our base case an engine generates 3.5x it achieved price in aftermarket revenues, which is conservative against RR's indication of 4x."

That valuation floor is higher than UBS previously thought, and the share price currently discounts a value for the installed fleet of 256p. Trajectory of its cash growth is an issue for the market, according to UBS.

Profits are also tipped to grow faster than expected at Power Systems, the high-speed diesel engines division. Recent positive numbers from industrial peers Caterpillar and Cummins are good indicator, too, and restructuring should also improve margins further out. 

This greater optimism drives a 6% increase in free cash flow (FCF) estimates for 2018, 9% in 2019, and 6% for the subsequent two years. On today's price, Rolls trades on a 6.9% FCF yield, or 5.6% discounted back. It's 4.9% at the 980p target based on estimates for 2019.

That's "attractive" for the sector, argues UBS, given aerospace and defence names have typically traded on 5-6%. A sum-of-the-parts valuation gives a 1,030p fair value. A mix of the three methodologies gives the 980p.

"For the stock to re-rate in H2 2017-18, ahead of the 2020 potential uplift in cash and earnings, we think the market needs to increase the probability level it allocates to the Rolls-Royce cash flow improvement profile," writes the broker.

"This could come from the perception/sentiment around management's ability to execute short-term actions to secure long-term benefits, as well as from the trajectory of cash between 2017 and 2020."

As always, investors will watch the Paris Airshow, due to kick off on 9 June, for any big orders for Rolls-powered wide-body jets. After that, next catalyst is half-year results early August.

While UBS makes a good case for further share price gains at Rolls, they have done well following the clear chart breakout (circled in red).

They're nudging a key technical level, too, having just hit the 50% Fibonacci retracement of the decline from 2014 high to 2016 low. That will make progress more difficult, but not impossible.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.