Why Rolls-Royce shares can rally 25% in 2023

Now that it ticks all the boxes, this expert has decided it’s time to take a more positive look at Rolls-Royce. Our City writer has the detail.

Backing for Rolls-Royce Holdings (LSE:RR.) amid a “number of positive catalysts” in 2023 today helped beleaguered shares in the engines giant near to 100p for the first time since April.

The fast start to the year for Rolls came as analysts at Jefferies upgraded the FTSE 100-listed stock to a “buy” recommendation and lifted their price target from 90p to 125p.

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The US bank’s more optimistic stance follows the recent recovery in international air traffic and an improvement in balance sheet position since last year’s sale of ITP Aero and wide-scale cost cutting programme in civil aerospace.

Jefferies added: “We had previously set out a number of conditions that would lead us to take a more positive look at Rolls-Royce. We see most of them now ticked.”

The shares were as low as 64.4p in mid-October and 87.3p in December, but rallied as far as 99.6p today as Rolls also benefited from improved risk appetite across the London market.

The mood towards travel-based stocks was helped by expectations for a recovery in demand from China after the world’s second-largest economy relaxed Covid restrictions.

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For Rolls, Jefferies notes that each percentage point of recovery in flight hours versus pre-pandemic levels will add around £30 million to free cash flow.

Based on its “cautious” estimates for a recovery in hours from 62% of 2019 levels in 2022 to 73% in 2023 and 95% the following year, the bank has increased its free cash flow forecasts by 22% for 2022 and by 9% and 2% for this year and 2024.

As long as Rolls breaks even on cash flow and continues the flight hours recovery, the bank expects 2023 will be the first step in the return of the group’s investment grade credit rating.

More than £2 billion of disposals, including the sale of strategic components supplier ITP Aero, and the repayment of UK finance export loans mean that Rolls now has no variable-rate exposure on its current drawn debt.

Despite the challenging economic conditions and potential debt cost impact of higher interest rates, Jefferies expect some credit ratings upgrades in 2023 and for Rolls to reach investment grade compatible levels of indebtedness by 2024.

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Other reasons for optimism include the removal of leadership uncertainty after Tufan Erginbilgic replaced Warren East as chief executive at the start of this month.

Jefferies believes the record of Erginbilgic on turnaround and green transitions is well suited for Rolls as it looks to ramp-up its operations at the same time as protecting the cost savings implemented by the previous management team.

His arrival raises concerns of a potential reset of expectations for the group, but Jefferies regards this as a low probability given how the group has not issued any specific messages of caution despite China's traffic weakness in 2022.

The bank’s valuation upgrade is also driven by the potential of the company’s New Markets division, which is focused on the global energy transition through opportunities such as the development of small modular nuclear reactors.

Jefferies said: “We see a number of positive catalysts for the group in 2023 including potential credit upgrades and further flight hours recovery which should build confidence on the group's mid-term potential.”