Determining if a company’s shares are cheap requires a comprehensive analysis of various factors.
After a blistering start to 2023, Rolls-Royce (LSE:RR.) shares are up by around 54% year to date. But since March, they’ve stalled and the company’s share price has traded around the 150p mark for a few months now.
Despite a bumper start to the year, could the shares still represent significant value? Let’s take a look.
Can Rolls-Royce fly high again?
Put simply, Rolls-Royce produces aircraft engines, marine propulsion systems, and power-generation systems. Its segments include Civil Aerospace, Defence, Power Systems, and New Markets.
A substantial amount of the company’s revenue comes from servicing aeroplane engines for large, long-haul planes, with business primarily based on how many hours those engines spend in the air.
As such, the group was hit particularly hard by the pandemic when so-called engine flying hours (EFH) plummeted. What’s more, they’re yet to return to pre-pandemic levels.
Nevertheless, I was encouraged by the announcement in May that EFHs reached 83% of 2019 levels in the first four months of 2023.
While it will be a few years before EFHs return to pre-pandemic heights, Rolls expects this year’s figure to remain in the 80%-90% range across the full year.
The aerospace and defence sector
What I particularly like about Rolls-Royce is its rock-solid market position in the defence and aerospace industry. As a sector with high barriers to entry, there aren’t many equal competitors for the group to jostle with.
This reflects in the company’s multi-billion pound order book, which I think will only continue to grow in strength. This is because order backlog looks set to grow further as the group benefits from a strong rebound in the aviation industry.
However, the aerospace and defence sector is riddled with environmental, social, and governance (ESG) risks. For example, product governance and business ethics remain key risk drivers for a company like Rolls-Royce.
According to Sustainalytics though, the group’s management of ESG risk is strong. To illustrate, it recently set up a safety, ethics, and sustainability committee to oversee ESG issues. On top of this, I admire the fact that executive compensation is tied to performance on these issues.
Debt levels remain a cause for concern
Another key risk with Rolls is the large net debt pile, which stood at a whopping £3.3bn as of March.
Significant debt levels can pose several problems for a company including limited financial flexibility and reduced investment capacity.
That said, now that the company has returned to positive free cash flow territory, I’m confident it should be able to keep pushing debt lower.
My final verdict
All things considered, I think Rolls-Royce shares offer significant value at their current price.
I’m confident the group is well-position to rebuild its balance sheet and achieve its mid-term ambition of returning to an investment-grade credit rating.
Once this is achieved, I reckon Rolls-Royce will be able to capitalise on its skills in sustainable power, harnessing new digital technologies and creating new business opportunities.
If I had some cash to spare, I’d hoover up some shares in a heartbeat.
