Analysis: an inside look at Rolls-Royce shares

Are Rolls-Royce shares about to make a comeback? Zaven Boyrazian takes a deeper dive into the financials, discovering a glaring problem.

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The pandemic has been quite a disruptive force for Rolls-Royce (LSE:RR) shares. But the aerospace sector is now making a steady recovery. And with the engineering firm’s other divisions stepping up to the plate, is this stock due for a comeback? Let’s take a look at how this business is performing and whether I should be considering it for my portfolio.

Roll-Royce returns to profitability

Management recently released its full-year results for 2021. But despite the downward trajectory of Rolls-Royce shares, there were some encouraging figures. Profits are back in the black for the first time since 2017.

Before getting too excited, net income from continuing operations was a measly £124m. That’s hardly the most groundbreaking performance. But compared to the £3.1bn loss reported in 2020, it’s undoubtedly an encouraging sign.

The question then becomes, where did these profits come from? Usually, an expanding bottom line is driven by an increase in the top line. But in the case of Rolls-Royce, that’s not what happened since revenue actually fell by around 2%. Therefore, this return to profitability can be solely placed by the recovery of margins.

With Covid-19 no longer wreaking as much havoc, operating costs are falling. However, management has also amplified margin growth by performing extensive restructuring. So far, £1.3bn of annualised savings have been realised, with plans to deliver more cuts in 2022. At the same time, the group is disposing of £2bn worth of non-core assets.

Needless to say, that’s a pretty significant cash injection. And the company intends to spend £1.2bn of it on research & development for new technologies, like its small modular nuclear reactors. The rest is being dedicated to paying off financial obligations to help restore free cash flow. That’s obviously good news for Rolls-Royce and its shares.

The shares versus the bears

Not every investor is convinced about the long-term potential of Rolls-Royce or its shares. And there are valid reasons to be concerned. Despite returning to profitability, free cash flow is still in the red, by £1.5bn. In other words, the company is still not generating enough money to fund its own operations.

The group’s upcoming investments and disposals will help in that regard. But the former could take years before bearing any fruit, and the latter is only a one-time benefit. In the meantime, debt continues to be a problem.

At the end of 2021, the company had just under £7.8bn in financial obligations (including lease liabilities). And that’s actually up from £7.3bn a year ago. The interest on these debts varies from 0.9% to 5.8%. Still, these rates are expected to climb now that the Bank of England is raising interest rates to combat inflation.

The bulk of these loans aren’t due until 2024, which gives the company some valuable breathing space. But it also puts a clock on how long management has to restore its free cash flow. And for each year cash flows stay in the red, the pile will only get bigger, intensifying the interest pressure on margins and, in turn, Rolls-Royce shares.

Personally, I remain unconvinced this is a lucrative investment for my portfolio today. When management can demonstrate an ability to wipe out the debt pile through more robust cash flows, I’ll reconsider my opinion. For now, I’m keeping this business on my watchlist.

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.

Zaven Boyrazian 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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