Shares of penny stock Rolls Royce Holdings (RYCEY) have more than tripled year-to-date, crushing the broader market returns in the process and valuing the company at $30.5 billion by market cap. A London-based company, Rolls Royce is among the most recognizable brands in the world - though in the U.S., the ADRs are fairly low profile, and trade over the counter.
Rolls Royce operates in the industrial technology space, with four business primary segments that include Civil Aerospace, Power Systems, Defense, and New Markets. It primarily develops and delivers complex power and propulsion solutions for mission-critical applications in the air, at sea, and on land.
In a recent shareholder presentation, the company emphasized it is part of attractive and growing markets. It has advantaged businesses in these markets with differentiated technologies, allowing it to grow at a faster pace than the overall market. With clear plans and strategic initiatives, Rolls Royce aims to unlock shareholder value over time.
The Bull Case for Rolls Royce Stock
Over the long haul, Rolls Royce aims to end 2027 with an operating profit between £2.5 billion ($3.14 billion) and £2.8 billion ($3.52 billion) and an operating margin between 13% and 15%. It expects free cash flow between £2.8 billion ($3.52 billion) and £3.1 billion ($3.9 billion) with a return on capital at 17% at the midpoint forecast.
It expects operating margins for the Civil Aerospace business to improve to 16% from 2.5% in 2022, while the Defense business should improve margins from 11.8% to 15%. The Power Systems business - the company’s most diverse segment - is positioned to improve operating margins from 8.4% in 2022 to 13% in 2027. It ended 2022 with an operating margin of 5% and free cash flow of £500 million ($628 million).
While the profit margin growth will not be linear, Rolls Royce expects to see improvement year over year, which should help strengthen the balance sheet and drive cash flows higher. So, how will the manufacturing giant achieve these goals?
In the Civil Aerospace business, Rolls Royce is focusing on the widebody commercial airline market and business aviation, while in Defense, it is targeting opportunities across verticals such as transport, combat, and submarines.
In the Power Systems business, Rolls Royce is focusing on power generation and marine end-markets, where it is experiencing strong demand. Moreover, it is eying potential partnerships in power generation and battery energy storage to grow its market position and broaden offerings, while benefiting from cross-business synergies.
Rolls Royce has also announced a divestment program to help it lower balance sheet debt and achieve an investment grade profile in the near term. It should also significantly improve the company’s net-debt-to-EBITDA ratio due to sustainable growth in free cash flows. Its improving liquidity position will then help Rolls Royce re-establish shareholder distributions.
Is Rolls Royce Stock Undervalued?
Rolls Royce is currently a slow-moving, low-margin manufacturing heavyweight. But its focus on improving the bottom line significantly should act as a tailwind for the stock price. In the next few years, it will more than double operating margins and cash flow, providing the penny stock with the flexibility to allocate capital towards growth projects and acquisitions.
Out of the seven analysts tracking Rolls Royce stock, five recommend “Strong Buy” and two recommend “Hold.” The average target price for Rolls Royce stock is $5.00, indicating expected upside potential of 34% from current levels.
