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.
