Valuation: Rolls Royce (LON:RR) 23H1

An update of my RR valuation, based on their half-year results for 2023. Was I wrong to have been so conservative?

I first published this post in August 2023 on the Trading 212 app in the Rolls Royce community under the username “Anathema”.

Around 5 months ago, I wrote a valuation piece on what I thought represented fair value for Rolls Royce. At that time, I felt 135p was top-end, without significant improvement in financial results.

We now have new results, so - has my opinion changed? Was I wrong? The share price would suggest I was: the stock has been trading above 200p since the start of August and is currently trading above 220p. I will lay out my thinking now.

what makes a fair value?

I calculate fair value based on EPS, a projected EPS growth rate, book value, the prevailing risk-free rate and the current WACC, bounded by a PE multiple to avoid the risk of divided by small numbers when WACC is very close to, or less than, the risk-free rate.

what did the recent results imply for EPS?

The H1 results implied a TTM gross margin, excluding depreciation expense, of 31%, 350 bps higher than the 2022FY results. At that rate, a full year improvement of 700 bps may be possible? A similar improvement was noted from 2021 to 2022, so that's perhaps not unrealistic.

EBIT margin increased 216 bps on a TTM basis, increasing from 5.8% to almost 8.6%. Net profit margin increased from a negative  number of almost -10% to a positive number of almost 10% (TTM). Although this implies an improvement of nearly 20% (closer to 18% without rounding), 2022FY was severely impacted by foreign currency contracts. Excluding that, RR would have been in profit last year, so the underlying improvement won't be quite as high as 18%, but even 10% TTM bodes well for the full year (H1 in isolation was around 16% net profit margin).

Interest payments are of a similar magnitude to last year on a TTM basis or projecting H1 results forward for full year, but the EBIT improvement means interest cover is markedly improved.

Revenue growth has been around 35% TTM, following a 20% increase 2021 to 2022, predominantly due to a recovery in civil aviation. At around £6.6Bn for civil aviation revenues (TTM), compared to £7Bn - £8Bn pre-Covid civil aviation revenues, there is maybe 10% - 15% further revenue still to come (in this segment), which may translate to a 5% - 6% increase in further overall revenue recovery before relying on future growth.

EPS of 18p (TTM) suggests an increase of around 33p from the stated 2022 EPS, but closer to an increase of 26p exc. foreign currency contracts. Company guidance issued with the H1 reports implies a mid-point EPS of around 16p, which aligns with the TTM results. These results would be the highest EPS results of all reports I've looked at, going back to 2016.

Equity remains negative, so book value is irrelevant for this valuation (ie will be set to zero, as shareholders are not liable for a company's debt).

Risk-free Rate and WACC

Risk-free rate on a TTM basis is now around 3.8%, as it was at 2022, up from around 1.5% in 2021. Although it has fallen slightly since the end of 2022, I think the change is minor and I don't expect the RFR to drop much from here at the moment (although a recession will change that, it will also change all of these performance and growth assumptions!).

Changes to effective tax levels, now that RR is profitable again, and a reduction in outstanding debt, have helped bring WACC down, but I still believe the effective interest rate is high, running at around 8.5%, up from around 6.3% last year. I calculate WACC to be around 19%, down from 22% in 2022.

changes to my estimate of Fair Value

I had previously been using EPS results from 2016 through 2022, implying EPS values of -£2.20 to +£2.29, but with a recent maximum of 1.44p EPS and an average of -36p. 5y EPS CAGR has been negative, as has EPS growth over most 12 month periods in that time.

I will now assume 16p - 18p is a reasonable estimate, with a growth rate of 5% to 10% per annum (as several segments have seen 20% over last few years ie close to 10% pa, but considering 'New Markets' is still loss-making and has been consuming more money each year since 2020).

P/E has typically been in single digits, but with the recent rise, it is now running at over 10. I will assume a terminal multiple of 5 - 10.

I will assume a RFR of 2% - 4%.

With these assumptions, I think fair value now has a P50 value around 110 - 115 pence. My top price estimate is now around 150p.

To get a value of 220p with an Eps of 16 - 18p, I need to use CAGR EPS growth rates of around 15% - 20%, coupled with a WACC / discount rate of 8% - 10%, which requires a much, much lower effective interest rate than I think is currently the case. Even expanding P/E to 20 - 25 is not sufficient without reducing that WACC value for my analysis.

Conclusion

For me, RR has demonstrated some very strong results with very promising growth prospects, but I believe it is currently trading on an assumption of a significantly lower debt / interest burden than is presently the case. I think the current price is implying many more profitable years and material changes to the debt burden. Which, admittedly, is a stated aim of the CEO.

So I am not sure I have been proven wrong yet, but i definitely appear to be more pessimistic than most shareholders!

I would potentially add to my shareholding up to an average of around 150p, as I do think Tufan will bring debt down, and that will in turn bring WACC down and boost valuation, but I think that risks severely eroding the gains I have seen recently, so I will think much harder about that before deciding to invest more at current prices.