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Is the Rolls-Royce share price undervalued?

Rolls-Royce share price: Is the Rolls-Royce share price undervalued?

After two years of disruption, things could finally be looking up for the civil aviation sector. However, despite the reasons for cheer, the Rolls-Royce [RR] stock price has fallen 36.3% since the start of the year to close at 78.25p on 10 May.

That’s a bigger drop than the declines experienced by Rolls-Royce’s competitors in the aircraft engine-making space, with General Electric [GE] having declined by just 22.3% and Honeywell [HON] by 6.1%, over the same period.

As the tourism sector begins to show signs of recovery, companies serving the aviation sector, like Rolls-Royce, could stand to benefit. According to the European Statistics Office, the total number of nights spent in travel accommodation across the EU hit 1.8 billion at the end of 2021, up 27% on 2020’s figure. Meanwhile, the number of commercial flights in Europe rose 156% year-on-year in March.

Why is the Rolls-Royce share price down?

Despite an improved outlook for the civil aviation sector, a number of factors are weighing on shares in Rolls-Royce.

Back in September, the biggest investor in the aerospace company – Causeway Capital, which owns a 9% stake in the stock – called for a board shake-up, saying it wasn’t sure if the company had “the right people now that will ask questions when sticky situations come up”.

The Financial Times reported that Jonathan Eng, a portfolio manager at Causeway Capital, hoped that incoming chair Anita Frew would bring in some “ fresh thinking”. Frew took over as board chair in October 2021. 

She faces serious challenges. Not only must Rolls-Royce navigate a recovery from the Covid-19 pandemic, but it also needs to figure out a convincing net-zero strategy.

Rolls-Royce took measures to temper these headwinds last year, raising £5bn in debt and equity in a bid to boost its balance sheet, which had been depleted by the pandemic. 

However, JPMorgan Cazenove warned in a note to clients in April that some of the new markets Rolls-Royce is pursuing as part of its transition to net-zero could be “lossmaking into the 2030s”. The note said that Rolls-Royce’s plan to tap into electric and nuclear power “offers good long-term sales potential but there is no guarantee of good profits”.

Another blow to the business was dealt last month, when Airbus [AIR] announced that airline AirAsia X had cancelled orders for 63 A330neo aircraft, which use Rolls-Royce engines. As of 10 May, shares in Rolls-Royce had fallen 17% since the announcement on 8 April.

Rolls-Royce sheds 75% in value in past three years 

Investors who have been holding on to Rolls-Royce shares for some time may be concerned about the current picture for the business. Over the past three years, the stock has shed nearly three-quarters of its value.

But it’s not all bad news. In its 2021 results, Rolls-Royce reported operating profits of £124m, up from the £3.1bn loss it saw a year earlier. The company also said that it expected to return to positive free cash flow at some point this year. 

The civil aviation sector, while improving, is also yet to return to pre-pandemic levels. As passenger numbers continue to increase, Rolls-Royce should see a boost. Michael Hewson, our chief market analyst, says: “Rolls-Royce gets 50% of its revenue from servicing and maintenance of commercial aircraft engines, and with airlines now starting to ramp up capacity for the summer months, this revenue should start to pick up quickly”. Hewson added that “the share price isn't reflecting that yet.”

According to Yahoo Finance, analysts have a consensus ‘hold’ rating on the stock, with five recommending this rating. Nine rate the stock an ‘underperform’, five a ‘buy’ or ‘strong buy’ and three a ‘sell’. The average price target is 117p, representing a 49.5% increase from its 10 May closing price.

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