Is the beaten-down Rolls-Royce share price a buying opportunity?

With the company’s share price below £1, Rolls-Royce shares look cheap. But Stephen Wright thinks that the balance sheet is a big red flag.

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The Rolls-Royce (LSE:RR) share price is down another 20% this month. That’s just the latest instalment in what has been a seemingly unending parade of bad news and share price drops since July 2018, when the stock traded at 1,097p. Now, with the Rolls-Royce share price around 93p, is it a buying opportunity for me?

The story

Rolls-Royce has been plagued with issues before during and after the pandemic. Before Covid, it had problems with the durability of its Trent 1000 engine turbine blades. The company believes that it has managed to resolve the issues with the Trent 1000. But doing so has cost it around £2bn and caused it to lose market share to its rivals. 

During the pandemic, restrictions on air travel negatively impacted the company’s business. Around 41% of Rolls-Royce’s revenues come from its civil aviation business, where it provides engines for wide-bodied aircraft. Decreasing air travel meant two things. First, orders for new aircraft declined, reducing demand for the company’s engines. Second, revenue from aftermarket parts and services fell. As a result, it raised around £2bn by issuing shares, restructured its operations, and sold off part of its business to stay afloat.

After the easing of travel restrictions, it has been hit by yet more bad news. The Russian invasion of the Ukraine, which has been terrible for so many reasons, has put the company in an even more precarious position. Airspace restrictions will likely hurt travel again and it’s worth noting that Russia is centrally involved in the supply of titanium and shifting suppliers is difficult. If doesn’t export raw materials, the situation for Rolls-Royce (and the industry more generally) could get even uglier.

The investment proposition

Rolls-Royce has thus seen a lot of bad news. Some of it has been specific to the group and some of it has been more general across its industry. For me, the crucial question from an investment perspective is how much of this is accounted for in the beaten-down share price.

For companies with a lot of debt (which Rolls-Royce has) I like to look at the enterprise value of the business. The enterprise value is market cap + debt – cash. For Rolls-Royce, this comes to around £13bn. The company managed to turn a £120m profit in 2021, which implies a business return of just under 1%.

If it can grow its earnings from here, then I think that it might be able to provide investors with a decent return. But I’m concerned that its debt is going to prevent it from doing so. 

Rolls-Royce’s total debt is about 67% higher than it was before the pandemic. As a result, interest payments have increased by about 2.5 times. They now account for around half of its operating profits. I think that it’s going to take the company a long time to get back to meaningful levels of profitability and its debt pile will leave it vulnerable in a rising interest rate environment. 

Ultimately, I think that the debt and the risks with its business probably justify its low share price. In my view, there are more attractive opportunities elsewhere.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has 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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