While 2023 has been a lacklustre year for most FTSE 100 stocks, the same can’t be said about Rolls-Royce (LSE:RR.) shares. The engineering giant has defied all expectations and rewarded loyal shareholders with an impressive 200% return in the last 12 months!
Considering that this firm tilted on the edge of bankruptcy only a few years ago, seeing such a monumental comeback is a pleasant surprise. But what’s actually driving this upward trajectory? And at 223p, is it too late to add this business to my portfolio?
What happened?
This once-struggling business’s drastic turnaround can largely be attributed to the actions of the new CEO, Tufan Erginbilgiç. His predecessor, Warren East, had already started implementing a comeback plan via the disposal of non-core operations to pay down debt. But Erginbilgiç seems to be moving ahead with this plan a bit more aggressively.
More streamlining of operations has resulted in further job cuts. And based on the current consensus, more employees are expected to face the chopping block following the completion of the group’s strategic review in the coming months.
While this is obviously an unpleasant time for workers, the strategy seems to be working. The natural recovery of the long-haul travel market is boosting revenue, while the improvements to operational efficiency have boosted profit margins from 2.4% to 9.7% in the first six months of 2023.
Free cash flow is back in the black, and the net debt position is shrinking. Pairing all this with a massively depressed valuation, courtesy of the pandemic, the result is an impressive triple-digit explosion in share price.
What’s next for Rolls-Royce?
Even after tripling, Rolls-Royce shares are still only trading at a P/E ratio of just 11.1. Meaning that the stock is seemingly still cheap. By comparison, the industry average is closer to 24. And that certainly corresponds with the recent revision in price target by UBS to 350p.
Assuming this forecast is accurate, that would suggest the stock can grow by another 57%. And that certainly sounds like a slam-dunk buying opportunity to me.
As exciting as this prospect may be, forecasts always need to be taken with a pinch of salt. Rolls-Royce may be in a far better position today than a few years ago. However, the group still has many cracks to patch up, especially regarding debt.
While its loan book has been almost entirely hedged, around £5.6bn of loans & equivalents are still on its balance sheet. Suppose management cannot bolster free cash flow high enough to repay these obligations before maturity? In that case, it may need to take on new loans at a higher rate to maintain solvency.
All of this is to say that the firm is not out of the woods yet. I’m certainly more bullish on this business versus a year ago. But I still want to see more progress before adding any shares to my portfolio.
