The coronavirus crisis has severely impacted the Rolls-Royce (LSE: RR) share price. The company makes most of its money on the service contacts it sells to airlines which purchase its engines. Under the terms of these contracts, Rolls get paid for every hour its engines are in the sky.
As such, when governments started imposing travel restrictions to try and control the spread of the virus, and airlines were forced to ground their fleets, Rolls’ income plunged.
However, over the past few weeks, planes have started to fly again. That suggests the outlook for the Rolls-Royce share price is beginning to look up.
Rolls-Royce share price is set to takeoff
According to its management, the global coronavirus pandemic created a “historic shock in civil aviation.” Most analysts believe it will take several years for the sector to recover from this shock.
With that being the case, the company is now predicting a worse-than-expected profit performance over the next few years. The group has pledged to generate £750m of free cash by 2022. That’s significantly below its previous target, but it’s still positive.
Considering this forecast, it seems unlikely the Rolls-Royce share price will recover to the level it started the year any time soon. However, the stock may still rise substantially from current levels.
If the company meets its 2022 free cash flow target, that implies the Rolls-Royce share price is dealing at a price-to-free cash flow (P/FCF) ratio of 6.6.
By comparison, the rest of the UK aerospace and defence industry is dealing at a P/FCF ratio of 14. This suggests shares in the UK engineering stalwart offer a wide margin of safety at current levels. What’s more, if the stock’s value moves back in line with the sector average, the shares could have the potential to double from current levels.
Time for take-off?
Clearly, the Rolls-Royce share price will continue to face some headwinds and uncertainty in the near future. The coronavirus crisis is far from over. It may take the airline industry longer than expected to recover from the recent slump.
Nevertheless, the company is one of the few trusted suppliers of engines for widebody aircraft in the world. This is a substantial competitive advantage. It’s also highly cash generative. The service contracts sold with engines produce a steady cash flow for the group for decades after the sale.
These factors should help the company meet its cash flow forecast in the years ahead. And if the business does hit management’s target, then it looks as if the Rolls-Royce share price has the potential to produce high total returns for shareholders in the years ahead.
As such, it may be a good idea to snap up a share of this global engineering champion today as part of a well-diversified portfolio.
The post Here’s why I think the Rolls-Royce share price can double appeared first on The Motley Fool UK.
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Motley Fool UK 2020