The Rolls-Royce (LSE: RR) share price has not had the prettiest few years, falling from highs of 426p in 2013, to its current price of 112p. Even so, in comparison to October last year, when it dropped below 40p, it has made a strong recovery. But while a number of risks do remain, I feel that there remains a large amount of upside potential. Here are the factors that require consideration for me to invest.
Past performance
Although I think that the Rolls-Royce share price is too cheap, this does not take away from the problems that face the company. Indeed, its poor performance can be traced back to before the pandemic even started. In the 2019 full-year update, it reported an operating loss of £852m, mainly due to a £1.4bn exceptional charge related to the Trent 1000 engine. Having problems pre-pandemic does not bode overly well for its post-pandemic future.
But the Covid crisis has clearly been the driving factor in Rolls-Royce’s recent decline, as demand for the aviation sector ground to a halt. This has been devastating for the firm’s civil aerospace division, which contributes the majority of its revenues. Last year’s figures are perfect examples of the struggles faced by Rolls. Here, it reported an operating loss of over £2bn, alongside negative free cash flow of £4.2bn.
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To shore up liquidity, it also had to raise £7.3bn in debt and equity. This has seen net debt increase to nearly £5bn, an extremely large amount for a struggling company with a market capitalisation of less than £10bn. And issuing more shares also had a devastating effect on the Rolls-Royce share price. Indeed, when the share issuance was announced, the price fell around 64% in one day. Around 6.5bn new shares were issued, which decreased the ownership stake of each individual shareholder. For the future, this also lessens the likelihood that the Rolls-Royce share price can return to its previous level, unless it can buy back some of these shares.
Problems for the future
Unfortunately, the likelihood of any shareholder returns right now are non-existent. In fact, one of its loan covenants restricts it from paying any dividends until at least 2023. Rolls-Royce also has negative shareholder equity. This means that its liabilities outweigh its assets, thus restricting its ability to pay dividends or buy back shares, even when it’s allowed to.
Consequently, the future does not look overly clear for this FTSE 100 stock. By its own estimates, demand for aviation will not return to 2019 levels until after 2022. Rolls is also exclusively exposed to long-haul flights, which are taking longer to recover. So uncertainty is here to stay, and this tops off the large number of risks that have already been mentioned in this article.
Why I think the Rolls-Royce share price is cheap
Having mentioned all these risks, it may seem peculiar that I find the Rolls-Royce share price cheap (in terms of it being a bargain rather than just a low price). But there are a number of key factors that I think will help lead to gains over the next few years.
Firstly, the company is being exposed to activist pressure from its biggest shareholder, Causeway Capital. Although this can sometimes cause friction, I like it when a large shareholder demands change, especially in a struggling company. This is because it can lead to new ideas, which can also prop up the share price. In the case of Rolls, Causeway is doing just this. In fact, it has already demanded board changes to boost fresh ideas, alongside urging a sale of its power systems business. Estimates suggest that this has a valuation of over £3bn.
Unfortunately, I don’t think that this sale seems likely. This is because there has already been resistance from the Rolls-Royce CEO Warren East, and it is doubtful whether the UK government, which has a golden share in Rolls, would even permit a sale. Despite this, I believe that the UK firm will still have to respond to this activist pressure, and board changes may be the likely outcome. Refreshed management could lead to greater shareholder optimism and the Rolls-Royce share price could rise as a result.
Can profitability also increase?
Another reason I think the Rolls-Royce share price is too cheap is because of the restructuring it has undertaken. This has included 9,000 job cuts globally, with 3,000 occurring in the UK. Although this is never good news, I feel that it was necessary, and it will hopefully lead to greater profit margins in the future. East has also promised to cut costs further in the next few years, another factor that should help profitability.
Opportunities also abound for Rolls, especially due to the push for decarbonisation in the aviation industry. Although this is a challenge for the group, it is equally a major opportunity. In fact, East has already pledged to make all commercial engines able to run on 100% sustainable fuel by 2023. The group’s interests in electric aviation and sustainable aviation fuels also bode well for a zero-carbon future. Hopefully, this will set Rolls apart from its competitors. These factors will hopefully increase profitability, hence making the Rolls-Royce share price seem too cheap at its current level.
What am I doing now?
It seems that Rolls has managed to survive the pandemic and is now preparing for the future. Strong liquidity and the rebounding aviation sector are two factors that will hopefully drive the Rolls Royce share price higher.
The recent half-year trading update was also better than expected, with the firm reporting a small profit of £394m. This equates to a price-to-earnings ratio of around 12 if it can sustain this profitability. As the aviation sector recovers further, I believe that profits will be able to grow in the next few years. The firm’s restructuring efforts should also help this. This means that the price-to-earnings ratio may fall even further, and this indicates to me an incredibly cheap valuation.
Due to this cheap valuation, I am very tempted to add Rolls-Royce shares to my portfolio. I may do so in the coming weeks, unless things take a turn for the worse!
