Rolls-Royce (LSE: RR) stock has not been good to investors over the last six months. The share price has fallen by 30% in that time, just as experts were starting to talk up the aviation industry’s prospects following the pandemic. At around 93p, Rolls-Royce is actually trading at levels close to its pandemic lows. It’s worth remembering that the aviation industry had taken an massive hit in early 2020, and the skies were certainly a lot less crowded.
So with prices hovering around 2020 lows, is Rolls-Royce now a risk worth taking?
Risks
The pandemic has been a huge turning point for this engineering giant, but not in a good way. Historically, civil aviation has been one of its core business drivers. Rolls-Royce’s aviation business earns money through flying hours, not just the sale of individual engines and their components. It is not the value of the engines that is calculated, but the flight performance hours that can be achieved with the engine. Flying hours were down by around 50% in the first half of 2020, causing massive damage to the firm’s revenue and leading it to take on more debt. Net debt has climbed from £3.6bn in 2020 to £5.2bn at the end of 2021. This will put the business in a weaker place.
Rolls-Royce has traditionally been a very profitable business. However, the capacity to achieve previous levels of profitability may be impacted by a pandemic-induced efficiency drive. Cuts to investment and trimming staff numbers may reduce long-term growth and revenue in the future.
Upside
Rolls-Royce is likely through the worst of the pandemic and we can assume that flying hours may return to pre-pandemic levels during the summer. High oil prices may impact the recovery of the aviation industry, but I think we can assume there is plenty of pent-up demand for travel. I also don’t think aviation fuel prices will lead to demand destruction either. In fact, I recently came across sub-£10 flights from Seville to London.
The company itself is pretty optimistic too. In its outlook for 2022, the Rolls-Royce said that it was confident of “positive momentum in..financial performance in 2022 despite the challenges and risks around the pace of market recovery, global supply chain disruption and rising inflation”.
Valuation
The engineering giant has a market cap of £7.8bn but its enterprise value sits at £13.04bn. That metric makes Rolls-Royce look cheap. But its price-to-earnings ratio is around 60, having returned a fairly meagre profit in 2021. The firm posted an underlying operating profit of £414m (statutory £513m). So according to that metric, there’s certainly cheaper stocks out there to buy.
I hold Rolls-Royce stocks and I’m quite confident on a share price recovery. The debt is certainly an issue but I think the company will come good in the long run. I’m also keeping an eye on the development of the firm’s small modular reactors (SMR). This week, the company said the SMRs will likely receive UK regulatory approval by mid-2024 and be able to produce grid power by 2029. Nuclear energy doesn’t have a history of being overly profitable but SMRs could be different.
