Surging 215% in the past year, it’s no surprise to see Rolls-Royce (LSE: RR.) shares topping the list of FTSE 100 best performers. But they are still 50% cheaper than their all-time high reached in 2013.
So should I buy into this growth phenomenon at its present price?
The bull case…
I can see two main reasons for buying in now. Firstly, rising profits in its biggest division, Civil Aerospace, and secondly, early successes in its transformation programme.
In the first half of 2023, large engine flying hours were 83% of 2019 levels. That compares to only 60% in the prior period. Little surprise therefore, that long-term service agreement shop visits rose 24% to 591.
I view the recovery in its core market as a necessary but not sufficient condition to invest. One of the reasons why its share price has performed so poorly over the last decade is that it relied on market recovery to drive success. It paid little attention to its low operating margins and high cost base.
Early this year, it launched its transformation programme. Composed of seven workstreams, its overall aim is to deliver a step change in performance.
Its efficiency and simplification workstream, which seeks to focus on synergies across its divisions, has delivered early successes. For example, procurement synergies relating to castings and rings have identified cost savings of up to $20m.
…And the bear case
Its colossal net debt position of £2.8bn is the number-one reason for avoiding its shares. That said, this is a vast improvement of £5.2bn at the end of 2021.
All of its debt is fixed with no debt maturities before 2024. However, a credit rating of BB places its bonds in the junk category. That matters because as its debt matures, it will be refinanced at a higher rate, pushing up interest expense.
The reason why its net debt has fallen significantly is due to disposals. But this speaks of a wider issue for the business.
For the last three years it has been in survival mode – slashing headcount and selling off key assets in order to survive. Today, it talks a lot about “transformation” but is less clear on how it intends to grow its top line.
Headcount reduction has been necessary. But how much key engineering talent has been lost as a result? And what about the morale of employees who remain? These questions will only really be answered when it faces its next crisis.
Should I invest?
At the moment, the stock has momentum on its side. But it wouldn’t take much for it to go into reverse.
As oil prices head back towards $100, airlines are raising prices. This is likely going to have an impact on air travel among an increasingly cost-conscious consumer.
Then there’s continuing supply chain problems. Cost efficiencies are helping, but there’s only so much juice that can be squeezed from a lemon.
Deleveraging and returning to an investment-grade credit rating is critical if Rolls-Royce is to thrive. But it’s too early to tell when this is likely occur.
I just get the feeling that I’ve missed the boat on the stock and the risk/reward ratio is no longer in my favour. Therefore, I won’t be investing.
