At 85p, are Rolls-Royce shares a slam-dunk buy?

The Rolls-Royce share price is in penny stock territory. Roland Head explains why he thinks this FTSE 100 stalwart looks undervalued at current levels.

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Airlines are reporting surging demand for flying. So why do Rolls-Royce (LSE: RR) shares keep falling?

This FTSE 100 stock has fallen by over 30% so far this year, even as unrestricted air travel has gone from being a hope to a reality.

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I can see a couple of possible reasons for the market to be cautious. A recession could lead to a delayed recovery in passenger numbers, especially in the important long-haul business travel market.

Looking further ahead, the need to decarbonise air travel is another potential risk. I think the heavily regulated nature of air travel should favour larger players like Rolls. But history tells me that large, mature businesses can sometimes struggle with major technological change.

Time will tell. But on balance, I think Rolls-Royce is a tempting buy at current levels. Here are three reasons why I’m thinking about adding Rolls shares to my stocks portfolio.

Growth opportunities

Over the last decade or so Rolls-Royce has been investing in new jet engines such as the Trent 1000, and XWB range of engines. These large engines are used to power newer widebody aircraft such as the Airbus A350.

Rolls says that its engines power 58% of the relevant aircraft in service today, with only one major competitor.

Similarly, the group’s Pearl engines, which are used on business jets, have an 88% share of the long-range sector of this market.

These young engines have between 70% and 90% of their estimated flying life ahead of them. Rolls-Royce says it’s well positioned to outperform the wider market in these sectors, thanks to its big market share.

Defence profits

It’s easy to forget that Rolls-Royce has a sizeable defence business in addition to its civil aerospace operations. Rolls’ defence business generated a £457m operating profit last year.

Rolls-Royce says that while short-term trading is not linked to geopolitical events, “governments are increasing their budget allocations towards defence activities”.

The company says it’s planning increased investment in this sector, to support further new business wins.

Rolls-Royce shares look cheap to me

Broker forecasts suggest Rolls-Royce’s annual profit is expected to rise from £360m in 2022 to £683m in 2024.

More importantly, surplus cash generated by the group (known as free cash flow) is expected to rise from £150m this year to more than £1,000m in 2024.

Based on these forecasts, the shares’ price/earnings ratio could fall from 22 in 2022 to just 10 times earnings in 2024. If debt repayments go to plan, Rolls might also start paying a dividend at that time.

A lower entry price now could mean bigger gains and a higher dividend yield in the future. That’s why I see Rolls-Royce shares as a long-term buy at this level.

Stock markets have turned cautious on this FTSE stalwart after a long run of problems. But in my view, now may actually be the best time for me to add Rolls-Royce shares to my portfolio.

Should you invest £1,000 in Rolls-Royce right now?

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Roland Head 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.

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 considered, so you should consider taking independent financial advice.

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