The Rolls-Royce (LSE:RR) share price has risen an impressive 54% in the year to date. However, even at current prices of 149p per share, the FTSE 100 engineer looks cheap on paper.
City analysts think company annual earnings will soar 156% in 2023. This means its stock changes hands on a forward price-to-earnings growth (PEG) ratio of 0.2.
Any reading below one indicates that an equity is undervalued.
So are Rolls shares one of the FTSE Index’s best bargains? Or does the engine builder command a low valuation for good reason?
Another bright update
Those exceptional earnings forecasts reflect the airline industry’s impressive recovery from the pandemic. And brokers don’t think Rolls-Royce’s expected bottom-line explosion this year to be a one-off.
Yearly earnings are expected to rise an extra 48% and 32% in 2024 and 2025, respectively.
A robust AGM update this week from Rolls illustrates the solid progress it has made of late. In it the company maintained its 2023 operating profit guidance of £800m to £1bn. It also claimed it remains on course for free cash flow of £600m to £800m.
In other news, between January and April, total flying hours of its engines hit 83% of 2019 levels, putting it on course to reach its 80% to 90% range for the full year. This is good news as the business makes significant revenues from servicing large engines on long-haul commercial aircraft.
Rolls also racked up new contract wins, including its biggest-ever order for Trent XWB-97 engines. Across its other operations the company has continued to rack up contracts at its Defence division. And at Power Systems revenues have continued to rise, order intake remains high, and pricing on new orders is improving, the FTSE firm said.
Travel recovery stalling?
Yet despite Rolls’ hot streak I’m still not tempted to buy its cheap shares. The business faces a raft of potential obstacles that could throw its recovery off course and affect shareholder returns.
My chief concern is a possible downturn in the civil aviation market. Weak economic conditions mean that demand for plane tickets among holidaymakers and business travellers could cool considerably.
Heathrow Airport said this week that “passenger growth may be levelling off,” with the recovery stabilising at between 93% and 95% of 2019 levels in the first four months of the year. Signs of similar slowdowns in other major airports could leave Rolls’ robust earnings forecasts looking unrealistic.
Other dangers
Supply problems and higher-than-normal cost inflation are other problems that look set to trouble profits. Indeed, in its AGM update, Rolls-Royce noted that “supply chain management remains a key operational challenge for us as original equipment and aftermarket services volumes increase”.
I’m also concerned about the company’s high levels of debt.
Improved trading and cost-cutting helped reduce net debt to £3.3bn at the end of 2022. But Rolls’ transformation still has a long way to go, and with its markets in danger of weakening again, the outlook for future dividends and the funding of its development programmes remains uncertain.
All things considered, I’d rather buy other cheap FTSE 100 shares today.
