- Rolls-Royce Group is a great value play.
- Rolls-Royce Group has a strong long-term growth advantage.
- Valuation supports MDNA's outlook for the coming years.
Rolls-Royce Group (OTCPK:RYCEY) is undervalued based on investors' short-term view of the stock, and their disregard of the long-term view of the company. Rolls-Royce is a provider of power solutions used in the aerospace (civil and defense), marine and energy industries. Their business model has some underlying strengths that were overlooked after quarterly results were released in mid-February.
CEO John Rishton first explained the order book which is comprised of approximately $115bn. For a company that recognized approximately $24bn in revenue for 2013, this is an extremely positive sign. Their order book supports MDNA's view of long-term sustainable advantage. My first thought when I saw this number was that their entire Sales and Marketing team can stop working, and they will have enough orders, already booked, to bring in more than $20bn for the next 4 years. I love companies like this. Long-term growth will bring value to your investment. When they released their quarterly earnings in mid-February, the short-term investors sold off, which ended up creating a buying opportunity for value investors. The company warned that revenue and profit will be flat for 2014. Rolls-Royce mentioned in the earnings statement, "This reflects a 15-20% decline in defense revenue, the consequence of well-publicized cuts in defense spending among major customers". A few minutes later, Rishton reaffirmed that there will be growth after 2014. Early that morning, short-term investors sent the stock plummeting from approximately $100 to $85 per share. Hint: it's cheap now.
Intrigued by its potential for future growth, I threw the numbers into a DCF model. Accounting for the different revenue streams and growth rates for each, I arrived at a similar conclusion to that of John Rishton. My 2014 numbers were decreasing as a result of a 20% decline in the defense division. However for the years until 2017, I took conservative growth numbers for the other product groups and ended up with a 4.5-5.0% increase each year. Even with modest estimates, the company will show underlying revenue and profit growth. Additionally, management is impressed by their cash position. CFO Mark Morris says, "We've had a good flow of deposits, and overall, broadly flat working capital and higher volume…and I'm confident we can get our inventory turns even higher. Finally, we've increased the full year payment to shareholders by 13%, reflecting our confidence in the business underpinned by our record order book." These healthy free cash flow estimates through 2017 gives us a target price of approximately $118 per share. I recommend $RYCEY as a BUY. There is a ton of value in this investment. The share plunge as a result of short-term investors' sentiment in mid-February has made it cheaper to buy at this moment. Once investors start to see the financials reflect growth, it will trigger a price increase. Don't let the "power play" expire without capitalizing on it!
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