The Rolls-Royce share price is under £1: should I buy today?

The Rolls-Royce share price has slumped since December, but Roland Head is watching the shares closely and reckons they could be cheap.

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After hitting a high of 135p in early December, shares in aero engine maker Rolls-Royce Holdings (LSE: RR) have slumped due to the impact of renewed lockdown restrictions. Rolls-Royce’s share price has fallen by more than 25% since 3 December, to under 100p. On a 12-month view, Rolls shares have now fallen by nearly 60%. Ouch.

Are Rolls-Royce shares a potential bargain? My colleague Graham Chester thinks they might be. I agree. But if I bought the shares today, I’d expect a rough ride before the company returns to reliable profitability. Here’s why.

What’s the worst that could happen?

I think it’s fair to say that many people underestimated the impact of the coronavirus pandemic. I think most businesses were unprepared too. They had not planned for a scenario where their revenue streams would be shut off by a health emergency and subsequent government action.

I’m not here to discuss the politics of this situation. But the reality is that in 2021, Rolls-Royce expects to record engine flying hours that are 45% lower than in 2019. No business can be expected to shrug off such a big loss. Rolls expects to see a cash outflow of £2bn this year, despite cost-saving measures.

Can things get worse? Rolls-Royce is banking on a recovery in flying hours during the second half of the year. But I don’t think we can be sure of this just yet. One risk I can see is that countries will return to normal this summer but might keep their borders closed for longer to protect against new virus variants.

Why I think the stock could be cheap

One challenge for Rolls-Royce is that it doesn’t make much money from selling its jet engines. Profits mostly come from after-sales servicing and support.

In normal times, this business generates plenty of cash. This is the key to my belief that Rolls-Royce shares could be cheap at their current price.

If I buy the stock, I’ll mentally write off 2021. Anything could happen and I expect the firm’s results to be awful. But from 2022 onwards, I believe the business should be operating pretty much as normal. At that point, I think the changes being made by CEO Warren East should start to deliver results.

Rolls-Royce’s own forecasts suggest that it could generate surplus cash each year (known as free cash flow) of £750m “as early as 2022”. I reckon that hitting this target would make the business look cheap at current levels, with a price-to-free cash flow ratio of just 2.5.

Rolls-Royce share price: my view

I think Rolls-Royce’s valuation reflects a couple of risks for potential shareholders like me. The first is simply that the outlook is still very uncertain. A return to normal is not yet in sight.

The second risk is probably more serious, in my view. Rolls-Royce has taken on around £4bn of new debt over the last year to help it survive the pandemic. At some point this borrowed cash will need to be repaid.

However, even when I include the impact of Rolls’ increased borrowings, my sums tell me that at a share price of £1, Rolls-Royce could be a good addition to my long-term holdings.

I’ve not decided whether to buy Rolls-Royce just yet. But this business is now on my watch list of shares to consider buying.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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