The Rolls-Royce (LSE: RR) share price has declined 20% year to date at a time when the leading UK market index, the FTSE 100 has managed to hold its weight, albeit with only a measly 0.4% gain. As air travel returns and governments invest more in defence, should I think about buying Rolls-Royce shares for my portfolio?
Tailwinds
Rolls-Royce has plenty going on for me to get excited. Guidance for FY22 is upbeat as it expects to generate positive free cash flow for the year. This is an encouraging sign considering that it will be three years since the firm achieved such a feat.
The return of air travel from a booming tourism industry and the current geopolitical climate could bring in more revenue. As a result, aircraft engines and maintenance will see more demand. The move of many governments’ budgets towards a bigger focus on defence also provides tailwinds for Rolls-Royce’s defence segment. Furthermore, the introduction of the Airbus A350 freighter serves as a great opportunity for its Trent XWB engines, with 58 additional engine orders since its launch.
Powerhouse
Rolls-Royce is also expecting to see its power systems segment gain more revenue. This comes along with the wider move towards independent energy sources. There are plenty of exciting projects I think Rolls-Royce could benefit from. For one, its incentive to create more sustainable energy and fuel alternatives. Synthetic fuels, hydrogen, and nuclear take advantage of industry tailwinds towards green energy. Additionally, its partnership with Tecnam and Widerøe to develop a zero-emissions ‘P-Volt’ commuter aircraft will be a game-changer if successful. Overall, these moves should do Rolls-Royce shares wonders in the long term.
Take-off aborted
With an exciting future, there are also several risks worth noting. Given that the majority of revenue for Rolls-Royce stems from its civil aerospace segment, it’s worth dissecting it. With most engines on order being the Trent XWB for the Airbus A350, this could potentially present a downside risk. As an increasing number of airlines complain about surface degradation issues on the A350, they may be tempted to follow in the footsteps of Qatar Airways to stop deliveries of the aircraft type. This would have an adverse impact on the main stream of revenue, as the Airbus A330neo and Boeing 787 bring in significantly less cash.
| Engine Type | Airframe | Market Share | Engines in Service | Engines on Order |
|---|---|---|---|---|
| Trent XWB | Airbus A350 | 100% | 764 | 859 |
| Trent 7000 | Airbus A330neo | 100% | 130 | 550 |
| Trent 1000 | Boeing 787 | 33% | 604 | 122 |
| Trent 900 | Airbus A380 | 48% | 168 | 1 |
| Trent 800 | Boeing 777 | 40% | 176 | 0 |
| Trent 700 | Airbus A330 | 60% | 1,146 | 0 |
| Trent 500 | Airbus A340 | 100% | 92 | 0 |
| Total | 3,080 | 1,532 |
Stalling financials
Overall, I think Rolls-Royce’s financials aren’t in a good position. While its short-term liquidity is fine, with no maturities before 2024, the long-term outlook doesn’t bode well in a high-interest-rate environment. Soaring debt, negative shareholder equity, and negative free cash flow, raise too many red flags for me.
I could argue that Rolls-Royce is too big to collapse. The duopoly of Airbus and Boeing, as well as NATO governments, are too reliant on the firm for it go under. So poor financials could be discounted as institutions and governments could bail it out in the worst-case scenario. Although it had deals of £50.6bn signed as of Q4 2021, guaranteeing revenue for the future, I still don’t think the shares are worth the financial risk. For that reason, I won’t be buying. Instead, I will be be placing Rolls-Royce on my watchlist until its financial situation improves.
