Rolls Royce Plc ( RYCEF) shares surged Monday after Goldman Sachs upgraded the aircraft engine maker to a buy, claiming that improving free-cash-flow could drive the stock 55% higher over the next 12 months.
"Rolls Royce has the potential to substantially increase FCF between now and 2020," noted Goldman analysts Chris Hallam and Peter Lapthorn. ""We expect company-defined FCF to improve from £120 million ($150 million) this year to £495 million in 2018, £1,018 million in 2019 and £1,547 million in 2020. Our 12m price target of 1030p implies 55% upside and an 8% FCFe yield in 2020."
Rolls Royce shares traded 4.24% higher Monday at 694 pence each by 10:00 GMT, clawing back some of the 9.34% decline the stock suffered last week.
The Derby, England-based maker of plane engines has struggled in recent years, with earnings dipping 5% since 2006, due in part to a sharp increase capital investment, R&D spending and cash injections to plug a shortfall in the company's pension fund. Goldman argues that spending will now level out, while the company is poised to reap the benefits of cash already sunk into the business.
"Between 2009 and 2016 Rolls-Royce raised spending on PP&E (property, plant and equipment) from £258 million to £585 million, reflecting in part the building of three major new facilities and the installation of associated equipment required to deal with the ramp-up on engine volumes from Trent 1000 and Trent XWB," wrote Goldman.
The benefits of that investment should be felt over the next four years, with output capacity likely to grow at a compound rate of 8%, meaning output could climb as much in the next four years as it did in the previous 10 years.
Rolls Royce will continue to make a loss until probably 2020 on the sale of each of its new Trent XWB engine, which are used on wide body aircraft such as the Airbus A350, but will begin to reap significant new cash flows from its key after-sale services. Aftermarket payments from airlines, which average about $440 per hour of flying could add £782 million to earnings between 2016 and 2020, making it the biggest contributor to earnings growth, Goldman predicts.
Beyond 2020 the company is also likely to benefit from a significant increase its sterling denominated earnings following last year's fall in the pound in the wake of Britain's vote to leave the EU. "This FX angle we believe supports a normal or expensive valuation multiple being applied to long dated numbers," wrote Goldman.