Are Rolls-Royce shares the biggest FTSE 100 bargain right now?

Rolls-Royce is the top-performing FTSE 100 stock of 2023, but analysts think there’s more to come. Stephen Wright looks at the potential challenges.

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Image source: Rolls-Royce plc

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I think the FTSE 100 has some great stocks for investors to consider buying. Recently, though, one in particular has been hitting the headlines. 

After a dismal few years, Rolls-Royce (LSE:RR) shares have been moving higher. And analysts at some of the top global investment banks are making positive noises about the stock.

Optimism

One of the major issues that has been facing Rolls-Royce in recent years is its debt, which spiralled during the pandemic. But analysts at Bank of America believe that this isn’t going to be an issue going forward. 

BofA believes the company is set to regain an investment-grade credit rating next year, allowing it to keep its borrowing costs under control. This, analysts believe, could see shareholders benefit from a reinstated dividend in 2024.

Morgan Stanley analysts also believe Rolls-Royce shares are a bargain at the moment. In their view, the market is significantly underestimating the effect the return of international travel will have on the firm’s cash flows.

With flying hours set to return to around 90% of pre-pandemic levels, revenue from the company’s engine servicing businesses should improve. According to Morgan Stanley, this isn’t being adequately factored into the current share price.

Both BofA and Morgan Stanley think the Rolls-Royce share price could move higher before the end of the year. So is this the FTSE 100 stock that investors should consider buying at the moment?

Risks

The key point that analysts are making in support of their optimistic predictions is that flying hours are set to close in on their pre-pandemic levels. But I think there are a couple of risks with that thesis.

First, I’m doubtful as to how durable the increased usage is going to be. As I see it, the company is still benefitting from a recovering economy, following the ending of travel restrictions.

That won’t last forever, though, and I’m anticipating a decline in demand when it starts to wear off. Consequently, I’m cautious about investing based on the idea of steady cash flow increases going forward from here.

Second, I think the market is underestimating the chances of a recession in the near future. In the event of an economic downturn, I’d expect flying hours to decrease and for this to weigh on the company’s earnings.

Of course, a recession would be a temporary dampener. But I view it as a significant challenge to the idea that Rolls-Royce might return to paying a dividend as early as 2024.

Should I buy Rolls-Royce shares?

Over the last few years, Rolls-Royce has been one of the best-performing FTSE 100 shares. The stock is up 234%, compared to a 25% gain for the broader index. 

The share price going up has clearly coincided with an improvement in the fortunes of the underlying business. But with the stock still some way from its pre-Covid levels, analysts think there’s more to come. 

There’s clearly some justification for this view. But with cyclical companies like this one, I generally look to follow Warren Buffett’s advice and be fearful when others are greedy. 

I think the market has gone from underestimating the firm’s future prospects (during the pandemic) to underestimating the risks now. So I’m looking elsewhere for FTSE 100 bargains at the moment.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Stephen Wright has positions in Bank of America. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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