It’s fair to say that Rolls-Royce (LSE: RR) shares have had a difficult time over the last few years. The share price fell over 50% in 2020 during the pandemic. After a short recovery in 2021, it has fallen 40.7% year to date at the time of writing.
The company, most commonly associated with its range of luxury cars, actually operates three core business segments. The motor car production side is wholly owned by BMW, and therefore is not associated with the publicly traded Rolls-Royce entity. The stock instead represents the civil aerospace, power systems, and defence elements of the business.
A few difficult years
Since 2018 the company has consistently been running at a significant loss, with an operating loss of £956m in 2018. This rose significantly during the pandemic, peaking at a loss of £2.1bn. Unsurprisingly this has not been kind to the company’s balance sheet, with total borrowing soaring. The level of borrowing reached almost £8bn in 2021, whilst cash levels have continued to fall, now just £2.5bn.
The company had been struggling with consistent profitability long before the pandemic, with exchange rate fluctuations often taking a large chunk out of bottom-line profits. So it was clear that the Covid-19 restrictions on travel would also hit Rolls-Royce hard.
Despite this, the company directors remained positive when announcing the significant interim loss. They outlined the over £1bn improvement in free cash flow, increased market activity, and continued recovery of the civil aerospace sector, post-pandemic. The company also provided a breakdown of the pre-tax loss in the first half of 2020. This loss could be attributed to over £2bn in financing costs. Exchange rate changes made up a significant portion of this figure.
Underlying fundamentals
Although I appreciate the positive outlook taken by management and can understand that the company may be on a better path, the underlying fundamentals are not encouraging. Profit margins are very low, as is the efficiency with which profits are generated on invested capital.
In addition to this, the company has high levels of debt. Any falls in income make repayments on this debt more difficult. Furthermore, the company had to cut the dividend completely due to the pandemic and is yet to reinstate this payment.
For these reasons, I would not be tempted to buy Rolls-Royce, even after the considerable fall in share price. The considerable reductions in profitability have meant that, despite the shares falling, the price-to-earnings ratio is forecast to hit almost 66 next year. This pricing issue, combined with uncertain fundamentals, means that I would not wish to add the stock to my portfolio.
