I’m not tempted by Rolls-Royce shares, here’s why

Gabriel McKeown outlines why he would not add Rolls-Royce to his portfolio as he begins selecting investments for the new year.

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After an extremely tough time during the pandemic, things were looking up for Rolls-Royce (LSE: RR) in 2021. The share price began to stabilise and the stock finished the year up almost 11%. However, this respite was short-lived, as continued financial pressure and weakening fundamentals hampered the company’s recovery. As the end of 2022 approaches, the share price is down almost 28%.

This decline needs to be considered in the context of the last few years. When looking back to pre-pandemic levels, the Rolls-Royce share price is down 63%. Despite these continued falls and the recovery narrative that often surrounds this iconic company, I am not tempted. The financial struggles are not yet over, and the fight for survival is ever-present.

Deep dive

When first looking at the company, it is essential to remember that although the name ‘Rolls-Royce’ is most commonly associated with a range of luxury cars, this stock represents the civil aerospace, power systems, and defence business elements. The car portion is wholly owned by BMW. By understanding this business, it’s possible to get a better insight into why the company started to suffer. Aerospace saw a considerable decline in demand throughout the pandemic, and as the company’s largest segment, this severely impacted fundamentals.

Currently, the company has very low profit margins, combined with high debt levels. Additionally, the cash return on invested capital is negative, indicating that the company is struggling to generate positive cash flow. Further weakness is indicated by the company having to cut the dividend during the pandemic. This still hasn’t been reinstated.

Wider context

It’s clear the pandemic increased the pressure on Rolls-Royce, and accelerated the share’s price decline. However, this wasn’t where the trouble started. Since 2018, the company has been running at a significant loss, starting with a loss of £956m in 2018. This then increased rapidly during the pandemic, hitting an operating loss of £2.1bn and a bottom line loss of almost £3.2bn.

The company has returned to some level of profitability in the 2021 financial year, achieving a full-year profit of £120m. This is by no means back to previous levels, and even generating a profit at this stage will not be enough. These last few years have not been kind to the company’s balance sheet, with total borrowing soaring. The level of borrowing reached almost £8bn in 2021, while cash levels have continued to fall, now just £2.5bn.

Future outlook

There are two positives to consider when looking at the company’s future outlook. The latest report outlined that it was experiencing a continued recovery in many underlying business sectors and that full-year guidance would remain unchanged. Rolls-Royce also outlined how the disposal of the company’s underlying holding, ITP Aero, allowed it to repay a £2bn loan due in 2025. Additionally, it now has £5.5bn of undrawn borrowing facilities in order to manage cash flow if needed.

Despite these announcements being a step in the right direction, performance is far below previous levels, and the company still has £4bn in debt. I believe that the next few years will continue to be challenging for the company, and therefore despite the share price fall, I am not tempted to add Rolls-Royce to my portfolio.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Gabriel McKeown has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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