After a prolonged period of stagnation in 2023, Rolls-Royce’s (LSE:RR) share price has sprung back into life. Up 36% during the past fortnight, the FTSE 100 engineer is now trading at three-and-a-half-year highs.
Yet at 210p each the company’s shares still look mega cheap on paper. City analysts are tipping a 194% increase in annual earnings in 2023. This results in a forward-looking price-to-earnings growth (PEG) ratio of just 0.2.
Any sub-1 reading indicates that a share is undervalued. The PEG ratio remains below this benchmark through to 2025 too.
So should I buy Rolls shares for my portfolio this August? Or would long-term value investors like me be better off buying other cheap FTSE stocks?
Forecasts upgraded
It’s easy to see why interest in Rolls shares has exploded. Two trading updates in quick succession have seen brokers significantly upgrade their earnings forecasts for the firm.
The engine builder continues to ride high as the recovery in the travel industry rolls on. In fact the scale of the rebound, along with the success of the firm’s transformation programme, has even taken the firm’s management by surprise.
So Rolls has lifted its underlying operating profit forecast for the full year to between £1.2bn and £1.4bn. That’s up from a range of £800m to £1bn.
Free cash flow guidance has also been upgraded in recent days to a range of £900m to £1bn from a previously predicted £600m to £800m.
The business is a major servicer of commercial plane engines and is thriving as the airline industry springs back. In fact, nearly half its revenues came from its Civil Aerospace unit in H1 as large engine flying hours leapt to 83% of pre-pandemic levels. Sales at the division rose by more than a third (38%) year on year.
But this isn’t the whole story. Rolls is also enjoying massive success elsewhere. Defence revenues rose 15% between January and June, while Power Systems sales leapt 24%.
Why I’m avoiding Rolls shares
This is all great news, of course. So why haven’t I bought Rolls-Royce shares?
The main reason is the large amount of debt that remains on the company balance sheet. This fell more than £400m in the first half. But it remained at a beefy £2.8bn as of June.
This worries me for several reasons. Product development in aerospace and defence requires vast amounts of cash, and high levels of debt can affect a firm’s ability to exploit new growth opportunities or fund existing programmes.
Significant amounts of drawn debt need to be repaid over the short term too. Some £500m is due in 2024, and another £800m needs repaying the year after. This is concerning as conditions in its end markets could sharply worsen if interest rates keep rising and the global economy remains weak.
New chief executive Tufan Erginbilgic will be delighted with the company’s turnaround so far. But Rolls is at the beginning of a journey, and buying its shares still involves a large amount of risk. This is why I’d rather buy other cheap FTSE 100 stocks today.
