As much as we all wish the markets ran only on actual company fundamentals and financial truths, the case is that for the most part, share prices have massive fluctuations based on speculation – the classic fear and greed directives.
The upside to this however, is that a savvy investor can see when this anticipation and fear is driving a price, rather than the true prospects of a company. I am currently looking at Rolls-Royce (LSE: RR) to see if it is one such opportunity.
As I write this, shares in the company are down about 10% compared to this time last month. The stock was hit early in August by the announcement of unexpected costs, and suffered again after ratings agency Moody’s downgraded their opinion of the company.
How bad?
Though at first glance, these two news stories seem bad, a closer look reveals they are perhaps not so dire as we might think.
Rolls-Royce announced that it spent £100m preparing for a no-deal Brexit, building up inventories and arranging logistics for such an outcome. The firm also said there would be an additional £100m cost over the next three years associated with its Trent 1000 engines – those that power Boeing’s 787 Dreamliner.
As with all Brexit-related issues facing companies, a negotiated deal may render expected problems mute, and indeed preparing for the worst does not necessarily mean that the worst will be the case even if there is no deal. Either way, this cost is a one-off charge that won’t have a real impact going forward.
In fact in the same breath as announcing this inventory build-up, the company confirmed it would be expecting to wind-down stocks in the second half of the year. Rolls Royce did say it had larger than expected cash outflows for the first half of the year, which is the main reason Moody’s gives for the downgrade of its credit rating, but again I don’t see this as much of a problem.
The downgrade from A3 to Baa1 will certainly raise the cost of debt for the company, particularly if it intends to raise finance in the bond market, but translating these concerns to its stock is a potentially flawed logic.
While reduced cash flow could certainly mean a company has a slightly higher risk of not being able to pay its bond coupons, for any company inflows and outflows vary — unless it becomes an underlying, degenerative problem, for investors there is little to worry about on this news alone.
Fundamentals
Elsewhere, things don’t look quite as bad. This week Rolls-Royce announced it would be selling off its French nuclear power business, and though the price is as yet unknown, the business is estimated to be valued at about £200m.
Despite the one-off costs, most of the first-half results were positive, with revenue rising 7% for the six months, operating profit increasing 32% and the earning per share loss reduced to 1.6p vs 2.5p last year.
Personally I am of the opinion that the company is not quite out of the woods yet, and Brexit may hold the key. I plan on watching this one closely, looking for the right time to buy, but that probably is not today.
