Rolls-Royce: a new target price and why the shares are a ‘buy’

This popular stock has received yet another boost after one City analyst backed the share price to go much higher. They also increase their target for BAE Systems. Here are the new numbers to watch.

The recovery of Rolls-Royce Holdings (LSE:RR.) shares continued today after a leading City bank backed the engines giant as one of its top picks in the European aerospace and defence sector.

Deutsche Bank switched its Rolls recommendation from “hold” to “buy” and upped its price target to 136p, representing possible 19% upside for shares on top of today’s 2.6p increase to 114.3p. The FTSE 100-listed stock had been as low as 64p in October.

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The bank’s improved stance reflects the “game-changing” impact of China’s re-opening and the late 2022 recovery in international air travel, events that prompted it to favour stocks with a focus on aftermarkets over those in original equipment.

It said: “Airlines need extra capacity to meet demand but persistent supply chain issues should continue to be a drag on Airbus SE (EURONEXT:AIR) and Boeing Co (NYSE:BA) deliveries in 2023, compromising an already challenging ramp-up.

“Airlines will thus be seeking to extend existing fleet life through servicing. Engine makers should benefit, with aftermarket growth likely above 20% in 2023.”

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Deutsche Bank analyst Christophe Menard said the more positive environment and the appointment of Tufan Erginbilgic as chief executive marked 2023 as a key milestone in the turnaround of the Rolls after the pandemic.

While the company’s other businesses in defence and power systems have performed well for some time, they have been unable to compensate for the profitability and free cash flow shortfalls in civil aerospace.

When it last reported in November, Rolls said large engine flying hours were at 65% of 2019 levels in the four months to the end of October and up 36% year to date. It said this reflected an uneven recovery around the world, with stronger performances in the US and Europe but lower travel in China and Asia.

Menard believes China's reopening is a watershed moment for the civil aerospace division as 23% of the A330 fleet is based in the country and their increased utilisation should help close the gap to rivals in terms of improved engine flying hours.

The other catalyst is the faster-than-expected recovery in international travel and the growing shortage of widebody capacity. With production rates relatively stable, Menard believes airlines will have little choice but to reactivate stored aircraft.

The A330 looks set to benefit again, giving a further boost to Rolls through its significant fleet of 1,722 Trent 700 engines with an average age of 11 years.

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Menard said 28% of A330s were still parked at the end of the fourth quarter, second only to the A380 and A340. He added: “The A330 should therefore be the primary beneficiary of aircraft reactivation, with a surge in shop visits likely at hand.”

Deutsche Bank expects aftermarket growth to bring in an estimated £540 million extra cash in 2023, creating a favourable backdrop for former BP executive Erginbilgic as he prepares to announce his first set of results on 23 February.

Menard said: “He is joining a financially healthier group that has successfully reduced operating costs by £1.3 billion, already granted wage increases to UK staff equivalent to 10%, and also managed to divest £2 billion worth of businesses, all in 2022.”

Today’s aerospace and defence note is also positive on BAE Systems (LSE:BA.) based on an increase in target price from 1,000p to 1,050p. Shares were below 600p this time last year, prior to the Ukraine war triggering a surge in global defence spending.

BAE’s order intake is expected to be close to £32 billion in 2022 and Menard believes that growth could take off more markedly from 2024. He added that recent tensions over the House speaker election should not materially affect US defence spending, while the UK is likely to remain committed to spending above 2% of GDP.

He said: “We expect free cash flow to continue improving and the share buyback programme to continue unabated.”