Rolls-Royce (LSE: RR) shares have been on a downtrend since November last year. With the stock near 73p, its plunged by around 47% over the past 12 months.
That wasn’t supposed to happen! The reasons for the company’s troubles during the pandemic have been well reported. But the partial recovery in airline flying hours should have propelled the business well along the runway to recovery.
And the way the company has been selling non-core operations to shore up it’s debt-laden balance sheet should have provided added impetus for the shares.
The business isn’t the stock
The problem for shareholders is that the business isn’t the stock. Rolls-Royce the business has been on a fast-recovering trajectory. City analysts forecast chunky triple-digit-percentage increases in earnings this year and next. Revenue is on the rise too. And operating cash flow has recently dragged itself out of negative territory.
However, the background to those positive figures is that Rolls-Royce has proved it relies on the health of the airline industry. And that’s a vulnerable and cyclical sector. But on top of that, the company carries a lot of debt. The business was making a loss in the two years before the pandemic even started. And I think that speaks volumes about the complexities — and costs — of the engineering industry.
If I was starting a business from scratch, or buying one outright, it wouldn’t be an engineering enterprise. There are easier ways to make money. And if I’d never heard of Rolls-Royce before, I wouldn’t consider buying the shares today, based on the current trading and valuation figures.
For example, the company currently pays no shareholder dividend. City analysts are forecasting a big recovery in earnings, true. But even after the recent slide in the share price, the advance is more than priced-in. The forward-looking earnings multiple for 2023 is just over 19. And I think that valuation looks full and well up with events.
Potential for higher earnings ahead
But the firm’s quality indicators don’t look so good either. The profit margin is running below 3% and the return against invested capital below 5%. If I’d happened to find this company on my screens by chance, I’d have likely moved on to examine the next opportunity.
However, flying hours in the airline industry are still at just around 60% of their pre-pandemic levels. So, theoretically, there’s potential for an increase of just under 67% to get back to the 100% capacity from 2019. And if the industry does fully recover, Roll-Royce could see its revenue and cash flows increase. Potentially, net profits could receive a significant boost.
Nevertheless, Rolls-Royce shares are not for me today. And that’s because I see stock opportunities that look better to me right now. For example, in the same industrials sector, I like the look of IMI. The business engineers and manufactures products that control the precise movement of fluids.
There are no guarantees of a positive performance from an investment in IMI shares. But the company delivered an upbeat trading statement at the end of July. It also has some impressive quality metrics. And the balance sheet features far less debt than Rolls-Royce’s. I’m thinking about buying it.
