Buying Rolls-Royce (LSE: RR) shares is easily the best investment decision I’ve made over the past year. Last November, I decided the FTSE 100 stock was too cheap to ignore and piled in, and I’m up a thumping 77.69%, so far.
Aircraft-engine maker Rolls-Royce was almost destroyed by the pandemic, as global fleets were grounded during lockdown. With Covid on the run and planes in the air, last autumn seemed a good time to buy. For once, I got my timing spot-on.
My brilliant buy
Yet lately, the excitement has waned. While the share price has soared 76.81% measured over 12 months, it’s up just 1.01% over the last three. So much for recent history. The big question is where will Rolls-Royce shares go next? In the short term, I’m not as excited as I was.
As a value investor, I prefer buying stocks when they’re out of favour. The last thing I want to do is go chasing momentum stocks after the excitement has started to fade. I’ve learned the hard way to be wary of strong past performance figures.
Rolls-Royce now looks expensive, with a forecast price/earnings ratio of 32.5 times earnings for 2023, and 20.4 times for 2024. A figure of 15 is typically seen as fair value, while today’s dirt-cheap FTSE 100 trades at just 8.6 times earnings.
Rolls-Royce smashed the lead index in the first six months of 2023 but now the company needs to show material progress if it’s to continue climbing. That’s going to take time.
There has been some good news. Earlier this year, Rolls-Royce announced notably its largest ever order for Trent XWB-97 engines, from Air India. Covid lockdowns are a fading memory, and I don’t think we can afford to repeat the experiment. The world may still fall into recession this year, which may hit flying hours, but I suspect the impact will be minimal. Plenty will still be able to afford it.
The time to buy may have passed
Rolls-Royce faces other challenges, as the global push towards net zero could squeeze it out of ESG portfolios. The company recently announced the development of a new small gas turbine engine designed specifically to power hybrid-electric flight, but we are decades away from emissions-free flying. It may have to invest a lot in fossil fuel alternatives for little return in the years ahead.
I’m in two minds about its net debt. Most analysts will point out that Rolls-Royce still owes £3.3bn, which is a lot for a £12.3bn company. Yet its debt pile stood at £5.2bn just 12 months ago, so it’s shrinking fast. That was mostly due to asset disposals though, and the remainder of the debt may prove harder to shrink. A knock-on effect is that this may deter management from restoring the dividend, which was axed in 2019.
Operating profits are forecast to range £800m-£1bn this year, with free cash flow of £600m-£800m. Yet JP Morgan has called these “highly ambitious” and “hard to reconcile with its historical performance”. I’m inclined to agree.
I’m hanging on to the shares I own, but as the FTSE 100 slides towards 7,000 I can see far better value out there today.
