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Should you buy Rolls-Royce shares in the rights issue?

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The Rolls-Royce Holdings (LSE: RR) share price has surged higher since the company announced plans to raise £2bn by selling new shares.

An optimist might say that the funding package — which will also include £3bn of new debt — means the company’s immediate future is safe. I agree with that. But the rights issue also highlights the scale of the problems facing the group.

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I think it’s important for shareholders and potential buyers to approach the rights issue correctly to avoid unnecessary losses. In this article I’ll explain what I’d do now and give my view on the long-term outlook for Rolls-Royce shares.

Rights issue: buy, sell or hold?

As I write, the shares are trading around 180p. Based on the rights issue share price of 32p, Rolls’ share price should fall to about 55p after the 6.4bn new rights are admitted to trading on 28 October.

If you take up your full allowance in the rights issue, then you’ll buy your new shares at 32p and will not suffer any dilution in the rights issue.

But if you own shares and do not want to invest any extra cash, I’d consider selling today and buying back after the rights issue. For example, if the share price falls to 60p after the rights issue, you’d be able to buy three times as many shares as you currently own. This would reduce the dilution you’ll suffer by not taking part.

If you don’t already own Rolls-Royce shares, I wouldn’t buy any until after the rights issue. With no sign of a return to long-haul flying just yet, I think Rolls-Royce share price will remain weak for a while.

Why I still think Rolls-Royce shares could be cheap

Rolls’ largest division is its civil aerospace business, which sells jet engines for widebody airliners — the kind used on long-haul flights. The problem is that these engines are sold at a loss. Profits are then made from years of after-sales service and support. With long-haul flying almost at a halt, revenue from servicing has also collapsed. Needless to say, no one is ordering new aircraft right now either.

Rolls expects to report a cash loss of £4bn this year, despite laying off 5,000 workers and cutting spending. It’s a grim situation, but I don’t think the situation is quite as bad as it might seem.

One reason for this is that Rolls has a 64% market share of engine orders for new wide-body jets. Although no one is buying these right now, the company’s big share of the market means that it should benefit immediately from any recovery in long-haul flying. I expect this to happen, probably during the second half of next year.

The second reason why I think Rolls-Royce shares could be cheap after the rights issue is the value of the group’s defence business. This division generated an operating profit of £450m over the 12 months to 30 June. Revenue and new order levels are both ahead of last year.

In my view, Rolls’ current valuation doesn’t reflect the value of its product portfolio. I can see some long-term value here, but I don’t expect a quick turnaround. I might consider buying Rolls-Royce shares in November, after the rights issue. For now, I’m staying on the sidelines.

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Roland Head has no position in any of the shares mentioned. 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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