Rolls-Royce (LSE:RR) shares haven’t been good to investors this year. The stock has been on a downward track, despite market conditions improving.
Over the last week, depressed Rolls-Royce stock lost another 7% of its value amid a global stock sell-off, which halted today.
Investors were spooked by the possibility that the US Fed will hike interest rates by 75 basis points this week after inflation unexpectedly jumped in May. This has been compounded by poor economic data from the UK and Germany.
Why is Rolls-Royce stock down?
Over the past three years, Rolls-Royce is down a whopping 72%. This is due to pandemic-induced disruption.
The civil aviation business is Rolls-Royce’s biggest earner, and this was hit hard during the pandemic when flying hours fell considerably. The group earns from flying hours in addition to engine sales.
This operating environment saw the business cut capex and take on more debt. As a result, Rolls-Royce is currently sitting on a huge amount of debt. Investment cutbacks will likely impact future revenue generation too.
Where will it go next?
Yet I think we’ll see the share price increase significantly in the coming months. There are three reasons for this. A civil aviation recovery, debt reduction and a strong order book.
Morgan Stanley upgraded Rolls-Royce stock to “overweight” on Monday, noting that the aviation business was closer to recovery than the share price suggested.
“Parsing the recent Civil Aerospace investor day suggests an earnings recovery is much closer than the market has priced in, while earnings and cash flow are directly geared to the next leg of a global aviation recovery,” Morgan Stanley said.
Flying hours for its large engine service contracts were up by a huge 42% during the first four months of the year.
The summer months will tell us a lot about where the aviation industry is versus pre-pandemic levels. Airlines have suggested they’re operating nearer to pre-pandemic capacity, although booking trends have changed.
Debt reduction is key to the Rolls-Royce share price recovery. The sale of ITP Aero and other businesses should raise around £2bn. This will really help bring debt down to more manageable levels.
Finally, there are also some positive signs coming out of HQ. The firm expects civil aerospace underlying revenues to grow in low double-digits, with an operating margin percentage in the “high single-digits“.
It has also registered a strong order backlog in its defence business. The firm may also be benefiting from a renewed focus on defence around Europe following Russia’s invasion of Ukraine.
A bargain buy for my portfolio?
Concerns about Rolls-Royce’s debt will sway metrics like the forward price-to-earnings and price-to-sales (P/S) ratios. In fact, Rolls-Royce’s P/S figure of 0.63 indicates that it makes more revenue than the overall value of the company. But of course, the value of the company is impacted by its debt levels.
However, I still think Rolls-Royce looks cheap and has solid prospects, assuming it can offload some business units to reduce debt. At 86p, I’m buying more Rolls-Royce stock for my portfolio.
