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Is the Rolls-Royce share price undervalued ahead of earnings?

With Rolls-Royce’s share price down nearly 30% year-to-date, the announcement of BP veteran Tufan Erginbilgic taking over as CEO in 2023 is hoped to help spark a rally in the stock. As the aerospace and defence company prepares to announce its half-year results, investors will be watching to see if it can reduce its ballooning debt.

Ahead of its half-year results on 4 August, Rolls-Royce [RR.L] has named BP veteran Tufan Erginbilgic as the man to replace Warren East (pictured) as chief executive. In a statement Rolls-Royce chair Anita Frew said: “He is a proven leader of winning teams within complex multinational organisations, with an ability to drive a high-performance culture and deliver results for investors.”

Jefferies analyst Chloe Lemarie described the appointment as “very solid”. Erginbilgic has a “blend of experience on profitability restoration, industrial sectors and energy transition”.

Investors will be hoping that Erginbilic, who will take up the role at the start of next year, can bring value back to the Rolls-Royce share price, which is down 29.93% since the start of the year to 89.04p at the close on 1 August. Although the stock has recovered 14.34% from a 52-week low of 77.86p on 11 May, it has fallen 40.82% since setting a 52-week high of 150.48p on 9 November last year.

The Rolls-Royce share price is “woefully mis-priced” at its current level, wrote Morgan Stanley analysts back in mid-June.

Flying hours up in first four months

The stock has been trading in a fairly confined range since the company reported its trading update for the first four months of the year in May. This is partly because civilian air travel hasn’t yet rebounded to the heights that had been expected this year. Nevertheless, long-term flying hours were up 42%. Longer flying hours equates to more jet engines needing to be serviced and maintenance carried out.

Overall, trading was in line with expectations and the company reiterated full-year guidance of low to mid-single digital revenue growth. It also reiterated that operating margins will be lower than in 2021 due to increased investments towards contract wins in the defence segment. Free cash flow is expected to turn positive during the second half of the year.

“This is a key turning point for [Rolls-Royce], which has seen its debt pile balloon as billions walk out the door to keep operations turning over,” said Hargreaves Lansdown equity analyst Sophie Lund-Yates, according to This is Money.Debt stood at £5.1bn at the end of 2021. The disposal of Spanish arm ITP Aero for £1.5bn, which should be completed within weeks, “will help get this under control, but ultimately we’ll need to see a business capable of standing on its own two legs before popping the champagne,” Lund-Yates added.

 

Order backlog mitigating inflationary pressures

If the company’s half-year results show signs of free cash flow moving into the black, then this should give the Rolls-Royce share price a boost.

The company’s defence segment, which has seen rising demand since the Russia-Ukraine war began, reported a strong order backlog for the first months of the year which should have helped the company mitigate any inflationary pressures during the first half of the year.

It’s anticipating “governments to increase their long-term budget allocations which will improve long-term growth prospects for our defence business,” said Frew at the AGM in May.

The company also has some near-term protection from its long-term sourcing agreements and hedging policies. Its power systems segment is holding more inventory than usual to manage supply chain disruptions, and this will impact cash conversion this year. However, the segment’s order intake was robust in the first four months. The first engines for power generation and industrial applications were approved for operation with sustainable fuels in May.

The shift towards clean and green energy, which Erginbilgic will oversee – as well as the recently announced development of a hydrogen combustion engine with easyJet [EZY.L] — could turbocharge power systems’ top line in the years ahead.

Revenue in the new markets business, which includes small modular reactors for nuclear power, will remain minimal for the years ahead, yet the segment could help to position Rolls-Royce as a clean energy play.

The Rolls-Royce share price has one ‘buy’ rating, three hold ratings and one ‘sell’ rating, according to MarketBeat. The consensus target price is 108.80p, which implies an upside of 22.1% from the most recent closing price.

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