Panmure Gordon has upgraded its valuation for shares in Rolls-Royce Holdings PLC (LSE:RR.), citing significant improvements in cash flow and profitability.
On a 12-month horizon, it thinks the stock is worth 550p (up from 400p) and says the stock could hit 820p in the next three years (up from 665p).
The new targets reflect Rolls-Royce's ability to overcome past challenges and leverage its installed base of civil aero engines to drive growth.
The company’s share price has surged sixfold over the past two years, bolstered by rising cash flow from long-term service agreements (LTSAs).
These contracts allow Rolls-Royce to collect payments from airline customers based on engine flight hours, creating a steady stream of revenue.
The net inflow from these agreements exceeded £1 billion annually in recent years, supported by a post-pandemic recovery in air travel and engine usage.
Rolls-Royce has also benefited from reduced cash outflows associated with one-off issues, such as the Trent 1000 engine problems and currency hedging costs, which had previously weighed on its balance sheet.
While these tailwinds are expected to fade, the growth of the civil aero engine aftermarket remains a central driver of profitability.
In 2023, approximately two-thirds of the £1.5 billion increase in civil aero engine operating profit came from the aftermarket segment, which includes engine overhauls and spare parts sales. Margins in this segment are high, helping to offset losses on the sale of new engines.
Panmure notes that while the rapid post-pandemic recovery phase is largely complete, Rolls-Royce’s focus on cost control and operational efficiency has positioned it well for sustained growth.
The company has reduced research and development spending as a percentage of sales and divested underperforming segments, allowing it to concentrate resources on its core civil and defence businesses.
Risks remain, particularly around supply chain constraints and working capital pressures. Despite expectations of improvement, Rolls-Royce continues to hold higher inventory levels and accommodate suppliers to maintain production stability.
However, Panmure’s analysis suggests that these issues are manageable within the context of the company’s broader recovery.
The brokerage's optimistic outlook also hinges on a rerating of Rolls-Royce’s valuation multiples. Historically, the company has traded at lower multiples than peers like Safran, reflecting years of underperformance.
Panmure argues that this dynamic is changing, with Rolls-Royce now reaping the benefits of its large installed engine base and a stronger cash flow profile.
The raised price targets signal confidence in Rolls-Royce’s ability to deliver long-term shareholder value, supported by its turnaround strategy and improving market conditions.