As a value investor, I’m always on the lookout for companies that have seen their share prices fall dramatically as this can often indicate an undervalued business.
However, it doesn’t guarantee it. That’s why the Rolls-Royce (LSE: RR) share price has recently appeared on my radar. Shares in the group have fallen around 50% over the past 12 months. And while the stock has recently recovered some of these losses, it continues to trade significantly below its pre-pandemic level.
Therefore, I’ve been reviewing the business to see if it offers value at current levels.
What’s behind the Rolls-Royce share price decline?
I think it’s fair to say that last year was one of the worst periods in the engineer’s storied history. As the pandemic rippled around the world, Rolls’ sales and profits evaporated. This caused severe liquidity issues across the group. Management had to negotiate an emergency fundraising to avoid a complete collapse.
But now, the business seems to be through the worst of it. In its 26 January trading update, the company told the market: “Trading in December was broadly in line with expectations across all business units.”
It went on to add: “Full-year 2020 group free cash outflow was in line with previous guidance, and in-year cash cost savings of more than £1bn were achieved from our mitigating actions.“
Management also seems to have put Rolls’ funding issues behind the business. Year-end liquidity was approximately £9bn, at the “upper end of the previously guided range,” according to the update.
However, despite these positive updates, the group warned its recovery in 2021 might be slower than expected.
I think this update was highly positive, although the market didn’t seem to agree. The Rolls-Royce share price dropped 10% on the day of the announcement.
Challenges ahead
It would appear investors are concerned about the organisation’s recovery prospects. That makes sense. If the engineering group continues to struggle, it may suffer further liquidity issues in future.
What’s more, cutting costs isn’t a sustainable long-term strategy. Rolls relies on its technological know-how to attract customers. It needs to invest to keep developing new technologies. Cutting costs to the bone may mean it can’t invest enough, which would have a detrimental impact on its reputation. Customers may avoid the business for good in this worst-case scenario.
So, it seems it isn’t out of the woods just yet. It could be sometime before the group returns to growth, and this lack of growth may weigh on the Rolls-Royce share price.
However, it seems as if the firm has put the worst behind it. A big positive, in my view. As such, I’d buy a limited position in the stock for my ISA as a recovery play. Rolls clearly faces some significant risks as we advance but, on the other hand, a quick economic recovery could be hugely positive for the shares.
