It’s been a rough couple of years for the Rolls-Royce (LSE:RR) share price. Even before the pandemic entered the picture, the company was having cash flow issues that were only exacerbated by the eventual arrival of Covid-19. Jump ahead to today, and the stock is down over 60% in the last three years.
But as devastating as the pandemic has been, management has made some substantial operational changes. And with the business ramping up again, is the stock now too cheap? Let’s explore.
The bull case for the Rolls-Royce share price
Over the last year, the firm has undergone some significant restructuring. Around 9,000 jobs have been axed, along with the sale of several non-core operations. While unpleasant, these decisions have delivered a £1.3bn cut in annual expenses and raised £2bn of capital for re-investment.
Meanwhile, with the pandemic loosening its grip on the travel sector, the firm’s primary aviation revenue stream has begun to recover. But solid progress is also being delivered across its Defence and Power divisions as well. A new multi-billion dollar contract has been secured with the US Airforce, while external investors have begun eying up the group’s mini-nuclear reactor technology.
Needless to say, this is all rather encouraging news. And it’s even translated into the company delivering a profit, albeit a tiny £124m, for the first time since 2017. Yet despite shifting back into the black, the Rolls-Royce share price continues to limp on. So is this a buying opportunity for my portfolio?
Taking a step back
As encouraging as the operational and financial progress has been, there remains a long road ahead. And seeing the lacklustre response from investors is quite understandable when looking a bit deeper into the numbers.
Profits may have returned, but the same cannot be said about free cash flow. Even with the previously mentioned cost savings, this was still firmly within the red by just under £1.5bn. While that’s drastically better than the £4.3bn cash outflow seen in 2020, this business’s financial health remains in question. Even more so now, as net debt continued to climb higher from £3.5bn to £5.2bn.
A rising debt level with restricted cash flows is not a great sign for the Rolls-Royce share price. But it’s even more concerning today as the Bank of England begins to raise interest rates in the fight against inflation. Consequently, Rolls-Royce’s profit margins could be about to take another hit and, subsequently, its days of being a profitable business could be short-lived.
The bottom line
Today, the Rolls-Royce share price places the market capitalisation at around £8.2bn. And compared to the £11.2bn of revenue generated in 2021, this valuation certainly seems quite cheap. But personally, I think the stock is low for a good reason.
Until management can restore the group’s cash flow, the balance sheet will continue to remain weak. And that’s not the sort of business I want to add to my portfolio. Therefore, I’m keeping this stock on my watchlist for now.
