Since Tufan Erginbilgiç took the corner office, the Rolls-Royce (LSE:RR.) share price has been on fire. The engineering giant saw its valuation more than double year-to-date. But with the price-to-earnings ratio sitting at just 10.5, the stock, at first glance, still seems to be relatively cheap.
So, is the current share price an opportunity for investors to hop onto the bandwagon and enjoy further triple-digit gains? Or is this secretly a value trap leading investors astray? Let’s investigate.
Why is the share price surging?
After facing the risk of bankruptcy, some radical decision-making was needed by Rolls-Royce’s management team. And that came in the form of a new CEO, the disposal of billions of pounds worth of non-core operations, and the termination of thousands of employees. And it might not be over yet as another 10% of its non-manufacturing staff could be facing the axe – roughly 3,000 jobs.
Seeing such turbulent decision-making is undeniably unpleasant, especially for those who have lost or may yet lose their jobs. However, Erginbilgiç’s strategy seems to be doing the trick.
As mentioned, billions of pounds have been raised and saved, enabling massive chunks of the firm’s debt to be eliminated. The company now boasts a 10.6% operating profit margin versus 5.4% a year ago and 0.6% a year before that. Subsequently, underlying earnings in its latest interim results landed at £797m, with free cash flow hitting £356m. The latter figure is particularly impressive since it gives management further flexibility to pay down its remaining debt obligations.
Today, the group has just over £4.9bn in long-term loans on its books. That’s down from £6.1bn in 2020. And with almost every loan now on a fixed-rate, further interest rate hikes from the Bank of England will have little impact on Rolls-Royce’s ability to keep up with its debt servicing costs.
Combining a far healthier balance sheet, recovering margins, and excitement for small-modular nuclear reactors is undoubtedly encouraging. And I’m not surprised to see investor confidence return, boosting the share price to its highest level since the pandemic kicked off.
What could go wrong?
Despite being in a much stronger financial position than in 2019, shares of this enterprise continue to trade at a discount to pre-pandemic levels. To some investors, this signals a bargain buying opportunity. However, not everyone is on board with this idea.
While I can’t fault the group’s profit margin expansion, the rapid growth in revenue across its divisions seems to be primarily driven by recovery at this stage. And it’s unclear what contracts, if any, Rolls-Royce has that can maintain this upward momentum once the recovery is complete.
The small modular nuclear reactors are the most obvious growth opportunity for this enterprise. But it could be another seven years before deployment even begins. Therefore, today’s seemingly cheap share price may be priced fairly in reality.
It all depends on whether Erginbilgiç’s strategy can continue to deliver excellent results, in my opinion. And while he’s certainly off to a terrific start, the jury is still out on whether he can continue in the long run.
