Rolls-Royce Holdings (LSE: RR) has had its fair share of problems over the past two years. The misfortunes of the travel industry due to Covid-19 have smashed profits and caused the business to rack up enormous debts. The Rolls-Royce share price is down around 50% since the start of 2020 as a result.
Mass vaccination rollouts have fuelled hopes of a recovery in the aviation industry more recently. And as a consequence Rolls-Royce’s share price has sprung 19% higher over the past 12 months. But a case can still be made that the engine manufacturer remains too cheap at current levels of 125p.
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Why? Well City analysts think Rolls-Royce’s profits will soar 210% year-on-year in 2022. This leaves it dealing on a price-to-earnings growth (PEG) ratio of 0.1. A reading below 1 suggests that a stock is undervalued considering its growth prospects, according to investing theory.
Reasons to buy Rolls-Royce shares
Fans of Rolls-Royce will argue that the skies are much clearer for the FTSE 100 firm looking ahead. Broker projections that annual earnings will rise an extra 5% in 2023 lend extra weight to hopes of a steady recovery.
In a key litmus test for the aviation industry aeroplane orders are beginning to rise strongly. Boeing announced last week it had chalked up 909 gross jet orders in 2021. That’s double the number the US planebuilder recorded in 2020 and 2019 combined. As one of the industry’s leading engine builders this is naturally excellent news for Rolls-Royce.
I also believe Rolls-Royce’s increasing focus on environmentally-friendly technologies could pave the way for big profits. Its plans to build a swathe of small-scale nuclear reactors across the UK will help the government to meet its emissions targets. It will also provide a bit more strength through industry diversification (in other words reducing the company’s reliance on the cyclical aviation industry).
The company is also creating less-dirty engines for aeroplanes and other vehicles. Its UltraFan plane engine, for example, is 25% more fuel efficient than a first-generation Trent engine.
On the other hand…
Rolls-Royce is clearly in a better place than it was a year ago. But I still have nagging doubts about investing in the company myself. It’s one of the UK’s most enduring engineering success stories, though outside circumstances mean Rolls-Royce is now saddled with debt (net debt stood at almost $5bn in June).
These massive debts could significantly hamper the company’s growth plans. They’ll be even more problematic if the Covid-19 crisis drags on and fresh travel restrictions ground planes again en masse. I can envisage Rolls-Royce adding to its debts or even tapping shareholders for more cash in this scenario just to keep the lights switched on.
The Rolls-Royce share price is cheap, sure. However, I believe this reflects the significant near-term risks facing the FTSE 100 firm and its buckling balance sheet. There are plenty of other cheap UK shares I’d much rather buy today.
