Rolls-Royce (LSE:RR) shares are currently trading for around 85p. Prior to the pandemic, it was trading for around 300p a share, so its clear that the emergence of Covid-19 was somewhat of a watershed moment for the British engineering firm.
I’m actually pretty bullish on Rolls-Royce, but let’s take a closer look at the company’s fortunes and explore why I’ve bought the stock.
A false recovery
So, if I had invested £1,000 in Rolls-Royce shares a year ago, today I’d have £930. Okay, that’s not phenomenally interesting and it belies the turbulence of the share price. A £1,000 investment six months ago would mean that today I’d have £680.
The share price gained towards the end of 2021, before falling slowly and then collapsing after Russia’s invasion of Ukraine. A year ago, many investors — including myself — looked at Rolls and assumed that the slow but steady recovery of the civil aviation industry would translate into a higher share price.
That hasn’t happened. There are concerns about debt — as of February, net debt stood at £5.2bn — and a misfiring civil aviation industry. Thousands of flights have been cancelled across Europe and the rest of the world this summer, and that’s not great for Rolls’s flying hours contracts.
Vastly undervalued
Net debt is clearly problematic, but the engineering giant is taking steps to deal with it. Business selloffs should bring in around £2bn, which will help reduce debt to manageable levels. The company currently has a price-to-sales ratio of just 0.58, and this exceptionally low figure is largely reflective of the debt impact.
Morgan Stanley recently upgraded shares in Rolls-Royce, stating that it was “the clearest example of mispricing” in its coverage.
One of the reasons for this is the recovery in civil aviation capacity, while there have been well-publicised setbacks for the industry this summer. Capacity is much closer to pre-pandemic levels than expected. IAG, for example, says capacity for Q3 is 85% of pre-pandemic levels, while Q4 will be at 90%.
But civil aviation isn’t Rolls’ only business segment. Last year, it generated £4.5bn from its civil aerospace division, £3.3bn from defence, and £2.8bn from power systems operations.
Global defence spending has been given a considerable boost this year, notably following Russia’s invasion of Ukraine. Fuelled by the Ukraine conflict, the business has already noted a backlog in orders.
There could be some more positive news coming amid reports that Britain and Japan are set to merge their next generation fighter jet programmes. The move could provide Rolls with an opportunity to get a foothold in a market long dominated by US suppliers.
The gold standard for quality
One reason I’m bullish on Rolls is because it operates in sectors where quality comes at a real premium. As such, I see less risk that emerging market players will reduce Rolls’s market share. When it comes to civil aviation, quality assurance is key. And at this moment in time there are few companies, globally, that can provide that.
A strong buy
For me, Rolls-Royce stock is a strong buy for my portfolio. There are challenges in the shape of debt and the so-called ‘travel chaos’. But it has incredible revenue-generating capacity right now, and I expect to see an impressive recovery in the coming months.
