Rolls-Royce (LSE:RR.) shares are slightly undervalued, but there are better candidates and inherent weaknesses with the stock make me cautious as an investor. I do not believe the hype other investors are playing into.
Company operations
Rolls-Royce is one of the world’s best-known engineering companies. But the shares do not include the luxury automotive side of the business, which is a subsidiary of Bayerische Motoren Werke AG. The stock represents the company’s aerospace, marine, and energy businesses.
Removing BMW from the picture changes the equation significantly, and Rolls-Royce has some key issues that counteract it trading at what I would consider just below fair value. So I’m still not adding it to my portfolio at the current price.
Financials
Long-term revenue has been up and down, and has risen from £9bn to £13.5bn from 2008 to 2022, which is unimpressive. The company has also issued £907m of debt over the past three years. That being said, the operating margin as of June 2023 is 9.41%, and it is ranked better than 60% of companies in the Aerospace and Defence industry. Operating margin is on the rise after five years of decreases and negative margins from 2015 until 2020.
Opportunities and risks
Rolls-Royce has significant diversification, particularly amongst its three core divisions, and US government defence contracts, which creates some long-term certainty in terms of revenue. $1.8bn valued contracts for the US Department of Defence were reported in 2022, planning to span five years.
The company’s debt-to-equity ratio is currently -1.13, signalling the company’s liabilities significantly exceed its assets. The debt-to-equity ratio has been negative since 2018 and hasn’t improved over the long term since 2020. This severely concerns me, and I primarily won’t purchase shares due to the unrealistic fundamental changes required for a turnaround any time soon.
Valuation
The price-to-earnings (P/E) ratio is currently 12.19 and is ranked better than 86% of competitors in Aerospace and Defence. I performed a realistic free cash flow discounted cash flow analysis, with an 11% discount rate, a 5% 10-year growth stage and a 4% 10-year terminal stage. This resulted in a fair value of £2.31 and a margin of safety of 4.33%; the shares are currently £2.21. To me, this valuation signals that adding Rolls-Royce shares to my portfolio would be uncompetitive over the long term.
Personal take
My analysis points towards the fact that Rolls-Royce shares are selling at a good price but have unpromising future financial prospects. I consider the shares to have too much debt and some safe contracts, but a lack of momentum in terms of revenue and depressed equity metrics.
Conclusion
Rolls-Royce shares are getting a lot of hype at the moment, but I believe this is unwarranted. I felt compelled to analyse the company to understand if it had a place in my portfolio as a value play, but I can’t find a compelling reason to buy them.
