Rolls-Royce (LSE:RR) shares have been on a downward track during the last six months, losing 30% of their value. The British engineering giant is now trading in penny stock territory after its fall.
As the falling share price suggests, Rolls Royce is facing some challenges right now. Debt is one of the biggest issues and that’s something it has to address fast.
But, Rolls-Royce is also a business with huge potential. Despite two poor years, it remains a leading player in civil aviation and defence — the latter sector is doing rather well right now.
So, at 88p, is now the time to buy Rolls-Royce stock?
Some serious challenges
Rolls-Royce has some serious challenges. The group’s largest segment is its civil aviation business, and this took a hammering. Rolls earns money through flying hours and maintenance, not just the sale of engines. But in the first half of 2020, flying hours fell by 50%.
With revenue from flying hours down, it was forced to take on more debt and reevaluate new projects. Debt reached £5.2bn by the end of 2021. This is something it hopes to reduce through the sale of ITP Aero for around £1.5bn and shedding other business units.
Rolls’ debt issue is so big, that it can’t pay dividends for two reasons. Firstly, the group is sporting a negative equity position — meaning liabilities outweigh assets. Secondly, the terms of its loan agreements bar its from paying dividends until at least 2023.
Reducing this debt by selling off businesses will cut Rolls-Royce’s revenue potential in the future. A reduction in capital expenditure and staff layoffs during the pandemic are likely to have the same impact.
Why I’m optimistic
Despite the above challenges, I’m optimistic about Rolls-Royce.
Firstly I anticipate the sale of some business units will make debt more manageable. This a really important objective for the firm. Servicing huge amounts of debt would really inhibit long-term profitability.
Secondly, we’re seeing some very positive signs from both the civil aviation and defence business.
In May, Rolls said that long-term service agreement flying hours for the first four months of 2022 were 42% higher than in the prior year. And airlines are expecting a return to normal this summer, amid huge pent-up demand for travel.
The firm also has a sizeable order backlog of £50.6bn, according to the April investors’ presentation. Much of this is related to civil aviation.
The defence business looks good too, buoyed by new UK military orders, including contracts relating to the Dreadnought programme — Britain’s next generation submarines that are among the largest ever built.
A strong order backlog in the defence business “gives us confidence on revenue, profit and cash conversion against the headwinds of inflation and supply chain risk”, the company said.
While I’m yet to see any evidence, I imagine the segment has been boosted by war in Ukraine. Peer BAE Systems, has said that it was braced for surging demand following Russia’s invasion.
So at 88p, I’m buying more Rolls-Royce shares. I believe this engineering giant will do well over the next year and beyond.
