I’m a big fan of buying value stocks. This investing strategy can supercharge the capital gains an investor makes over the long term. But so far I haven’t been tempted by Rolls-Royce Holdings‘ (LSE:RR) cheap shares.
On paper the FTSE 100 aero-engine builder offers terrific value for money. City analysts think annual earnings here will soar 156% in 2023. This leaves the company trading on a forward price-to-earnings growth (PEG) ratio of 0.2.
A stock is considered to be undervalued if it trades on a value below 1.
Rolls-Royce shares have long traded on a low PEG ratio. However, concerns over cooling air travel and Rolls’ high debts mean I’ve invested in other cheap UK shares instead.
Is now the time for me to hit the buy button for the stock?
More good news
My question is especially timely following the release of bubbly Ryanair trading numbers today. The Irish flyer made post-tax profits of €1.4bn during the financial year ending March, just below its all-time annual highs posted five years ago. And it said it expects profits to rise again this year.
The airline also said it expects to carry 185m passengers in financial 2024. Last year the business moved a total of 168.6m travellers, up 13% from pre-Covid levels.
Ryanair’s release in itself isn’t a big deal for Rolls-Royce. But it’s the latest in a string of impressive trading updates from across the travel industry. Fellow FTSE stock and British Airways owner IAG hiked its full-year profits forecasts just over a fortnight ago.
With industry profits surging, demand for new aircraft — and thus orders for Rolls’ engines — could be on course for sustained growth. Turnover at the FTSE company’s aftermarket division might also soar should plane traffic keep improving.
Clouds ahead?
However, aviation businesses like Rolls can’t take things for granted in the current macroeconomic environment. With the global economy struggling for traction and inflation remaining above historical norms, the airline industry could soon hit fresh turbulence.
This threatens the rebound in holidaymaker numbers and solid ticket sales to business customers. It also means that cargo traffic could continue to plummet.
Latest International Air Transport Association (IATA) data showed global cargo volumes (as measured in cargo tonne-kilometres) dropped 7.7% year on year in March.
Debt problems
On the one hand I might be prepared to accept some short-term turbulence given the bright outlook for air travel further out. Passenger numbers are tipped to boom as travel-related spending from emerging markets picks up. The cargo market is also on course for significant growth as global trade increases.
But Rolls-Royce’s huge debts remain a significant problem to me as an investor.
Okay, net debt fell from £5.2bn at the start of 2022 to £3.3bn by the end of the year. But this is still uncomfortably high and may undermine Rolls’ ability to finance its cash-intensive development programmes.
These financial liabilities also cast a shadow over when the business will begin paying dividends again. And when there are lots of FTSE 100 value stocks also offering big dividend yields, this is a dealbreaker for me.
All things considered, I’m happy to continue avoiding Rolls-Royce shares right now.
