I was trawling through a list of over sold stocks the other day on the look out for good quality value stocks and I came across Rolls Royce. Now this one has had a couple of profits warnings this year with the latest one coming this month and suggesting a flat outlook for next year. This in addition to the recent sell off in the broader market has left the shares looking over sold at 780 pence as you can see in the chart below. They last traded at these levels in 2012 and it looks as though these levels might provide some support. In addition they are due to start a £1 billion (6.8% of market cap) share buy back programme before the end of the year assuming the disposal of the Energy gas turbine and compressor business is completed as expected, so this should also provide some support to the share price. Gaps on the chart from the profits warnings this year leave some decent potential medium term upside targets at 900 pence and 1200 pence.
So what about the fundamentals - well eye balling these they show an erratic earnings trend in the medium term, which begs the question why is the market getting so upset about the recent set back in the short term? Aside from that they have grown the dividend steadily from 14.3 pence in 2008 to 22 pence in 2013 for a compound growth rate of 9% per annum over that period. However, I note that forecasts for the next two years show a slowing to 5 to 6% probably reflecting the steady downward trend in earnings forecasts for this year and the flat outlook for next year. Despite the earnings downgrades the forecast dividend of around 23 pence for this year is still expected to be covered around 2.8x by earnings.
In addition the company has cash on the balance sheet, some unique technology which should provide some sort of moat and barriers to entry. In addition to this in their recent update despite the short term difficulties they did upgrade their medium term forecasts to include the suggestion that Group Return on Sales could rise to 13.5% to 14.5%. This compares to a range of around 9 to 11% in recent years, so if this can be achieved it suggests there could be some upside to the valuation.
Talking of which the shares at these levels trade on around 12x with a 3% yield and as such look reasonable value for a good quality business with a solid balance sheet a a good track record of increasing dividends. So it could be an interesting long term buy down here as academics have noted that share prices tend to be more volatile than the underlying earnings, although the earnings here are certainly quite unpredictable in the short term. Nevertheless, I was also encouraged to see that Woodford Asset Management are planning to roll with it for the long run, so I'll be keeping a beady eye on it to see if it can soar again like a high flying bird. Of course it could continue to sink like a Led Zeppelin towards 500 pence to 600 pence if they have a third profits warning (quite common) or if economies and markets tank again and airlines etc. start going bust and cancelling / deferring orders again, but then I guess there would be plenty of other stocks in trouble if that comes to pass.