Why Rolls-Royce’s shares are still risky

Rolls-Royce’s shares have cratered in recent years, and a bet on a turnaround in the company’s fortunes could be a shot in the dark.

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Since its all-time high of £12.50 in January 2014, Rolls-Royce’s (LSE: RR) shares have been on a downward spiral. It isn’t hard for me to understand why, as the company has made a net loss in four of the last six years. However, with asset sales and streamlining of its business, is Rolls-Royce set for a brighter future?

The company’s main revenue driver is its jet engines, sold to aviation companies globally. Therefore, it’s understandable that Rolls-Royce made a loss over the past two years due to the major Covid-related disruptions to the aerospace industry. Due to this, the company had to issue large amounts of debt and equity in order to fund operations and stay afloat. This has significantly diluted shareholders since 2020 and is part of the reason for the company’s poor performance of late.

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What does the future hold?

However, there are two reasons to be optimistic about the future prospects of Rolls-Royce. Firstly, the company has recently begun its initial round of asset disposals, aiming to bring in £2bn in order to shore up its highly geared balance sheet. The company also plans to slash overheads and restructure the business, improving overall efficiency.

The second reason for positivity is its movement into the nuclear space. The company is building small modular reactors (SMEs), which use uranium to produce energy. These could be hugely important to the clean energy transition as they are very efficient and produce small amounts of waste. Also, as oil and gas prices remain high, governments around the world will be desperate to find any potential solution to the current energy crisis, potentially benefitting Rolls-Royce.

Risk assessment

However, there are several risks if I were to invest in the company. After eight years as CEO, Warren East is planning to step down at the end of 2022. This is a major disruption at a time when the management team is key to the turnaround of the business. There is already a risk of poor execution by the management team, which would lead to a continued downtrend in the company’s share price, and the added uncertainty of a new CEO makes this risk even greater.

Also, the shares are not cheap, at 57x last year’s earnings. Don’t get me wrong: if management can successfully deleverage the company’s book while growing earnings, the valuation multiple should normalise. If this were to come to fruition, there could be a huge pay off for investors, as positive free cash flow leads to a reduction in debt levels and a potential dividend payment. However, comparing the company to PayPal, which trades at a 29x price-to-earnings multiple with revenue estimated to grow at 17% per year into 2026, is betting on a major turnaround at Rolls-Royce even worth it? I guess only time will tell, but I remain on the side line for now.

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Peter McMullan has positions in PayPal Holdings. The Motley Fool UK has recommended PayPal Holdings. 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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