Interactive Investor

Share of the week: An icon revived

24th February 2017 16:03

Lee Wild from interactive investor

It's been a funny week for equity markets. After a pause for breath, the FTSE 100 is down 100 points and below 7,200 for the first time in a couple of weeks. Friday was a stinker, with the blue-chip index diving through two key trendlines.

This paves the way for a further trip lower, although only a dip below 7,100 will trigger the panic button, according to our technical analyst Alistair Strang.

Miners have struggled, and HSBC is down sharply, but there's a bunch of blue-chips sitting on fat profits this week, among them BT, up 5%, Capita almost 7% and Intu Properties slightly more.

However, one has done twice as well as its nearest rival and is the best-performing share in London outside the AIM market. Up over 14% this week, step forward Rolls-Royce.

This is an odd one in that these gains come less than a fortnight after the engines maker reported a biggest ever annual loss of £4.6 billion. Results were largely in line with expectations, and the spectacular deficit was blamed largely on a revaluation of its $38 billion currency hedge book, used to manage shifts in foreign exchange rates.

Having already rallied into the results on the back of a bullish update in January, and without any further catalyst in the numbers, profit-takers moved in and Rolls shares fell sharply.

However, analysts at Goldman Sachs have had a good look at the books and decided Rolls is a share worth buying. The rating goes up from 'neutral' to 'buy' and is added to the broker's 'Conviction List'.

Upside

It now thinks there's potential upside to 1,030p - it had been 743p previously - implying profits of over 35%.

Goldman's view is largely predicated on free cash flow (FCF). And that's OK with Rolls chief executive Warren East, who points out that new, complicated accounting procedures mean cash flow is a far better measure on which to value the business.

Rolls has pumped a fortune into the business in recent years, doubling spend on property, plant and equipment to £585 million.

However, it should now begin to reap the rewards over the next few years.

"Rolls Royce has the potential to substantially increase FCF between now and 2020. We expect company-defined FCF to improve from £120 million this year to £495 million in 2018, £1,018 million in 2019 and £1,547 million in 2020."

True, Rolls will likely keep losing money on Trent XWB engines fitted to Airbus's A350, but higher margin aftermarket services should be a significant driver of profit growth in the years ahead.

Goldman's backing was enough to thrust Rolls shares above the three-year downtrend, which could provide a launchpad for further gains.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.