Citigroup has increased its price target for Rolls-Royce Holdings (LSE:RR.) by around 50%, raising it to 1,647 pence from 1,101 pence after stronger first-half results prompted substantial upgrades to the bank’s long-term profit and cash flow forecasts.
Citi lifted its longer-term earnings and cash generation estimates by between 30% and 40%, with accelerating demand from data centre customers emerging as a major growth driver for Rolls-Royce’s Power Systems business.
Despite the higher valuation, the bank retained its “neutral” recommendation. With Rolls-Royce shares trading at £15.25, Citi’s new target implies an expected total return of 8.6%, below the 15% required by the broker to justify a “buy” rating.
Power Systems overtakes Civil Aerospace in Citi valuation
One of the most significant changes to Citi’s investment case is the growing importance of Power Systems.
The division has now overtaken Civil Aerospace as the largest contributor to the broker’s fair-value assessment. Citi’s sensitivity analysis assigns 504 pence per share of value to Power Systems, compared with 353 pence for Civil Aerospace.
Strong demand from data centre operators is underpinning the division’s growth outlook. Citi now forecasts a long-term Power Systems margin of 23.5%, considerably above Rolls-Royce’s own medium-term target range of 18% to 20%.
The bank increased forecasts across all three of Rolls-Royce’s main divisions, although it applied different assumptions regarding the sustainability of recent improvements.
Citi cautious on Civil Aerospace profit boosts
For Civil Aerospace, Citi’s upgraded estimates incorporate contract catch-ups that contributed a net £497 million during the first half, together with £125 million of releases from onerous contract provisions.
However, the bank cautioned that much of this benefit was non-recurring and non-cash.
Over the longer term, Citi expects annual contract catch-ups to settle at approximately £100 million, substantially below the level recorded during the first half.
Defence margins expected to normalise
Rolls-Royce’s Defence division achieved a record margin of 21% in the first half, comfortably exceeding the company’s medium-term target of between 14% and 16%.
The performance was supported by a favourable sales mix, including strong international business and higher aftermarket activity.
Citi does not expect the 21% margin to be sustainable over the longer term, instead forecasting Defence margins of approximately 16% to 16.5%.
Small Modular Reactor business adds further value
Citi separately values Rolls-Royce’s Small Modular Reactor operation at between 87 and 90 pence per share.
The broker used two approaches to estimate the business’s potential value. One assumes Rolls-Royce eventually scales production to eight SMR deliveries annually, while the other models the company capturing a 25% share of a global market potentially reaching 400 units by 2050.
Citi adds the resulting SMR valuation to enterprise value when calculating its overall equity price target for Rolls-Royce.
Citi forecasts £5.69 billion of shareholder free cash flow by 2028
The broker’s discounted cash flow model assumes compound annual profit growth of 12.2% over the next five years, followed by 8% growth between years six and 10 and a perpetual growth rate of 3%.
Its valuation also incorporates operating cash conversion of 110% and a weighted average cost of capital of 9%.
Citi expects Rolls-Royce group sales to reach £22.99 billion in 2026 before increasing to £28.62 billion by 2028.
Free cash flow available to shareholders is forecast to climb to £5.69 billion in 2028, reflecting the broker’s substantially more optimistic view of the group’s long-term earnings and cash-generation potential.
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