Warren Buffett‘s Berkshire Hathaway does not own Rolls-Royce (LSE:RR) shares. But that doesn’t mean it’s not a stock that meets his investment criteria.
Buffett has repeatedly said that investors should only own companies with a competitive edge. He buys when stocks are meaningfully undervalued, but avoids distressed assets.
So let’s take a closer look at Rolls-Royce, and explore why I think this stock would meet the legendary investor’s criteria.
A distressed asset?
Let’s start by assessing one reason why Rolls-Royce might not meet Buffett’s criteria. It’s not what you’d describe as a distressed asset, but it certainly faces challenges.
Rolls has been working hard to pay off its debts, and completed a £2bn sell-off of business units in September. These funds were used to pay down near-term debt. However, Rolls still has £4bn in debt obligations — all on fixed-interest rate terms — between 2024-2028.
Revenue dropped substantially during the pandemic, and it’s still not back at pre-pandemic levels. The company, which gets paid when its engines are airborne, said hours flown by its customers were now at 65% of 2019 pre-Covid levels.
It’s worth noting though, that other firms do use debt to leverage greater revenue. And despite continued pandemic-induced disruption, cash flow is once again positive.
Meaningfully undervalued?
In the summer, Morgan Stanley analysts said shares in the engineering giant were “woefully mispriced” — at the time Rolls was trading for 88p.
The stock then tanked during the short, but disastrous, premiership of Liz Truss. With Rishi Sunak at the helm, a more predictable macroeconomic environment, and a recent positive earnings update, the share price has jumped 30% in a month — back to 90p.
There are metrics to support the notion that Rolls is still undervalued. It trades with an enterprise value-to-sales ratio of 1.11 versus a sector average of 1.72. Meanwhile, the enterprise value-to-EBITDA ratio is in line with the sector median. Other metrics also suggest the firm is trading at a discount to its peers in the industrials sector.
Competitive edge
Rolls-Royce is synonymous with quality. And that’s important as the sectors the company operates in — aviation, defence, and power systems — put a premium on quality.
The firm is a market leader in aviation, particularly in the provision of engines used on long-haul flights. It’s not the type of market where customers are willing to skimp on quality to get a better price. Rolls is also at the cutting edge of efficiency — its UltraFan demonstrator aero engine is 25% more fuel efficient than the first Trent engine models.
The firm is also responsible for maintaining and developing the UK’s nuclear submarine fleet — there aren’t too many competitors here and nuclear tech is closely guarded. In many respects, this provides Rolls with defensive characteristics.
So while Buffett might not own Rolls stock, I think it could meet the billionaire investor’s criteria. It’s also worth noting that Rolls-Royce is down 63% over three years (-33% over one year). But despite the £2bn in business unit sales, the company isn’t substantially smaller. In fact, remaining business units are demonstrating strong growth.
I already own Rolls-Royce stock, and I’m looking to buy more this year.
