The Rolls-Royce (LSE:RR) share price has been impressive in 2023. At 213p per share, the FTSE 100 engineer has soared around 125% in value since January 1.
The astonishing thing is that, despite these massive gains, Rolls shares still look exceptionally cheap on paper. They trade on a forward price-to-earnings growth (PEG) ratio of 0.1. A reminder tha a reading below 1 indicates a stock is undervalued.
Analysts expect the company’s earnings to tear 369% higher this year. And they expect the bottom line to expand a further 21% in 2024, too.
But something is bothering me about City forecasts right now. If the company is so cheap, and profits are tipped to keep rising strongly, then why isn’t it an overwhelming ‘buy’ in their opinion?
Of the 17 brokers with a rating on Rolls-Royce shares, less than half (eight) have slapped a ‘buy’ rating on it. Nine have a neutral rating on the stock, though admittedly none believe it’s a ‘sell.’ This is according to stock screener Digital Look.
Debt problems
One reason could be the huge amount of debt that the FTSE firm still has on its books.
Through a combination of cost-cutting and asset sales, net debt has toppled from £5.2bn at the end of 2021 to £2.8bn as of June. However, Rolls may struggle to continue slashing its financial liabilities following the end of its divestment programme and as efficiency improvements slow down.
Of particular concern to me is that a lot of this debt has to be repaid over the next two years. Half a billion pounds is due next year, and another £800m is due in 2025.
Cash questions
Having huge debts is especially problematic for capital-intensive companies like Rolls-Royce.
Testing, developing, and manufacturing complex hardware like jet engines and power generators requires massive amounts of cash. However, because a lot of the company’s cash flows are dedicated to servicing debt, the amount of money it has left over to invest in new and existing projects can be limited.
The good news is that cash flows are also improving rapidly at the company. Indeed, last month Rolls upgraded its free cash flow guidance for 2023 to a range of £900m to £1bn. This was up from a previous £600m to £800m forecast.
The verdict on the shares
But generating strong and sustainable cash flow beyond 2024 could become a colossal challenge. And not just because its streamlining programme is cooling down.
The weak global economy means that plane travel could slow markedly following the post-pandemic bounceback, which could in turn damage demand for Rolls’ aftermarket services. High cost inflation across the aerospace industry is another threat to profit and cash flows.
Rolls-Royce shares could prove a great way to capitalise on the long-term travel boom. But I’ve been burnt before by buying stocks that carry huge amounts of debt and face near-term uncertainty. For this reason I’ll keep ignoring this FTSE 100 share and buy other value stocks instead.
