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Are Rolls-Royce shares a poisoned chalice?

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Key points

  • Rolls-Royce shares are up over the past year, but still heavily down over two years.
  • Risks include the struggling civil aerospace division due to Covid-19 and high debt levels.
  • Potential upside could come from disposing of business areas or growing other divisions.

Over the past year, the Rolls-Royce (LSE:RR) share price has risen by 17.7%. This isn’t a bad return for an investor, but if I look further back over two years, the picture changes. Over this time horizon, Rolls-Royce shares are down 45%, taking into account the full impact of the pandemic. So even with the bump higher from 2021, is this a misleading return that could see me holding a poisoned chalice for 2022?

Reasons to stay away

In my opinion, the main reason why Rolls-Royce shares have been hit so hard over two years is due to the civil aerospace division. This is the area that houses the turbofan aircraft engines. Naturally, this division is most profitable when the engines are being heavily used. This contributes to more servicing requirements, and new engine installations. 

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Unfortunately, the pandemic has meant that most airline operators have struggled. Lower flying hours have reduced demand for the services and products from Rolls-Royce. 

Looking forward, will flying hours get back to 100% of pre-pandemic levels? I think so, but not anytime soon. Even with some pent-up demand, I think a lot of people will still be cautious about travelling internationally, either for business or pleasure. This is the big concern that could mean that Rolls-Royce shares could stagnate this year. In short, even though the stock looks cheap, it might struggle to find any positive catalyst to break higher.

A second reason worth noting is the net debt figures. As of the half-year report for 2021, net debt stood at £3.1bn, up from £1.5bn at the end of 2020. This is a sizeable liability that the company will have to deal with for years to come. Even though it’s needed, it’ll likely take a long time to reduce this, during which it has to pay interest on the debt. 

Upside potential for Rolls-Royce shares

On other other hand, the stock might offer high returns. For example, consider the high debt figure. The business has made it clear that by disposing of business divisions and cutting other costs, it’s aiming to boost liquidity and cash flow. This has already been seen, with the sale of ITP Aero to a private equity business for over £1bn late last year.

Another reason for optimism for Rolls-Royce shares comes from the diversified nature of operations. Civil aerospace might take a long time to recover. But this isn’t the only line of business for the group. It has a large defence division, as well as power systems, electrical and other areas. With this spread of options, the company could grow in these spaces and offset the drag from civil aerospace.

I personally think that it’s too early in 2022 to make a call on the key issue of civil aerospace performance due to Covid-19. Therefore, I’m going to wait for the moment before considering whether to buy. 

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Jon Smith and The Motley Fool UK have 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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