The Rolls-Royce (LSE: RR) share price is down 35% this year, having slid below the £1 mark since early April. As the travel industry rebounds, management has guided for the firm’s civil aerospace division to breakeven this year. With that in mind, Rolls-Royce shares could be a bargain at this price. However, there are also a couple of warning signs to look out for.
Why is Rolls-Royce flying so low?
Rising interest rates, rocketing jet fuel prices, and sky-high inflation — need I say more? Making matters worse are the recent airport disruptions. Pent up demand for air travel and a lack of workers has resulted in one of Britain’s main airport, Gatwick, placing flight caps. Additionally, staff at Heathrow Airport will be striking next month, during the industry’s busiest week. If we are to connect the dots, flight cancellations lead to fewer flying hours, meaning less revenue for Rolls-Royce.
The engine manufacturer also faces its own set of worker issues. The company offered a £2,000 bonus to workers last week to mitigate the cost-of-living crisis. However, unions rejected the offer and stated that it, “Falls far short of the real cost of living challenges”. A lack of resolution could lead to a walkout by Rolls-Royce employees, thus hurting its top line even further. But forking out bigger paycheques could impact its bottom line too. For that reason, the board is stuck between a rock and a hard place.
That being said, Rolls-Royce still has a ginormous backlog of orders. The firm reported a total deal value of £50.6bn in its FY21 results. It’s also managed to ink several large deals since, such as being the main engine manufacturer for the new Airbus A350-F and Qantas‘ Project Sunrise.
Nonetheless, Rolls-Royce is much more than just its civil aerospace division. In fact, its other segments (Defence, Power Systems, New Markets) could very well act as a hedge against a potential slow down in travel. This is largely due to the effects of the Ukraine war.
Aside from the potential increase in revenue from government defence spending, European countries are also desperately clamouring for energy independence. As such, the UK government has allocated £210m worth of funding to Rolls-Royce to further develop its nuclear, small modular reactors (SMR). If successful, this could end up positioning Rolls-Royce as a market leader in nuclear energy in the UK.
Rolls-Royce SMR is able to produce a repeatable factory-built power station, that relies on tried and tested nuclear technology, it can be constructed and made operational far more quickly than conventional bespoke nuclear design and build technology. The Rolls-Royce SMR approach lowers cost, reduces uncertainty and risk for developers and crucially, allows countries around the world to address their urgent need for low carbon energy.Source: Rolls-Royce SMR
Despite the exciting ventures however, its other segments rely on the success of its Civil Aerospace division, which generates the bulk of the company’s revenue. Without positive free cash flow (FCF), Rolls-Royce cannot further develop its other divisions and ventures.
Having taken on large piles of debt during the pandemic, the company is still very much recovering. With negative shareholders equity and a slim profit margin for the time being, most of its FCF will be spent on repaying its debt.
Therefore, even though the Rolls-Royce share price is trading at a low level, I’ll only be keeping it on my watchlist for now. Until its financials improve, I won’t be investing in its shares. Instead, I’ll be investing my money in other growth stocks with much better balance sheets.