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The Rolls-Royce (LSE:RR) share price has risen more than 80% over the past 12 months. It has been lifted by the airline industry’s robust post-pandemic recovery.
Some market experts believe that things will continue to get brighter for the FTSE 100 firm, too. Take equity analyst Andy Chambers of Edison, for instance. He has predicted:
As civil markets continue to recover, aided by the return to international traffic operations from China, defence spending accelerates and power markets transition to lower emissions, Rolls-Royce looks well positioned to improve competitiveness, increase cash flows, strengthen the solid balance sheet and improve shareholder returns.
Certain investors might believe that the cheapness of Rolls’ shares fails to reflect this sunny picture. Today the enginemaker trades on a forward price-to-earnings (PEG) ratio of 0.2.
Any reading below 1 indicates that a share is undervalued. So should stock pickers buy the business for their portfolios in May?
A fragile recovery?
As an investor myself I have large reservations around buying Rolls-Royce shares.
As I say, rebounding airline traffic has bolstered the firm’s top and bottom lines by boosting demand for its aftermarket services. Yet it’s far from certain that the company can keep this momentum up in the current macroeconomic landscape.
Susannah Streeter, equity analyst at Hargreaves Lansdown, has predicted that Rolls will “likely feel the sting of any prolonged economic downturn.” A combination of weak growth and high inflation might choke off demand for plane tickets.
A long road ahead
As a long-term investor, though, my worries stretch beyond how Rolls will perform if the airline industry experiences more temporary turbulence.
The company hasn’t had a good record when it comes to using its cash efficiently. New chief executive Tufan Erginbilgic has even described Rolls as a value-destroying “burning platform” that “underperform[s] every key competitor out there.”
Extensive restructuring is very encouraging and helped the business become free cash flow positive again in 2022. It recorded inflows of £500m versus £1.5bn worth of outflows in 2021.
But Rolls’ streamlining journey still has a long way to go. And this creates big risks for investors.
Charlie Huggins, head of equities at Wealth Club, has said that “transforming Rolls Royce will be far from easy” due to the capital-intensive nature of its operations.
He added that “while tackling the extreme complexity and inefficiency is a start, it probably won’t be enough.” Huggins noted that a long-running cultural transformation will also be required to turn around its fortunes.
It’s important to mention Rolls’ colossal debts as well, and how they cast a shadow over its long-term profitability.
Pleasingly, net debt at the group fell sharply from £5.2bn in 2021 to £3.3bn last year. But these huge liabilities still raise questions over how it will manage to fund its cash-absorbing development programmes. They also represent a major hurdle to the business restarting its dividend policy.
There’s a lot I like about Rolls-Royce and its shares. The civil aviation market is tipped to grow strongly over the coming decades. Defence spending is also on the increase. And the company’s high barriers to entry put it in great shape to capitalise on these themes.
Yet on balance it still poses too much risk in my opinion. I think investors would be better off buying other cheap UK shares in May.