At first glance, Rolls-Royce (LSE: RR) shares look cheap from a price perspective. The stock is currently changing hands at 98p, significantly below its five-year high of 378p.
As a value investor, this has attracted my attention. I like to buy shares in companies when they’re trading at low prices and, right now, it looks to me as if shares in the aerospace group are in that territory.
Buying stocks at low levels doesn’t guarantee profits. In fact, it doesn’t guarantee anything. Still, it’s a strategy I’m perfectly comfortable following because I’m aware of the level of risk it entails. It may not be suitable for all investors.
Rolls-Royce shares under pressure
Before I buy any company, I always try to understand why the stock is trading in the way it is. Rolls-Royce is under tremendous pressure. The pandemic has caused the group’s revenues to plunge, and cash is flying out the door faster than it’s arriving.
According to the company’s latest trading update, it expects a cash outflow of £2bn in 2021. This is only a rough guide.
The vast majority of group sales come from aircraft engine maintenance contracts. These are based on the number of flying hours each unit records. So, the more time Rolls’ engines are in the sky, the higher its revenues.
Alongside its latest trading update, the company warned there’s “significant uncertainty” surrounding the global aviation industry’s recovery. That means its £2bn cash outflow projection may be subject to significant revisions.
To offset the uncertainty, management cut around 7,000 jobs in 2020. It’s planning 9,000 job losses in total by the end of 2022. Total cost-saving efforts so far have shaved £1bn off group expenses.
All of the above suggests a pretty terrible outlook for Rolls-Royce shares. But, over the next three to five years, the company’s fortunes could improve.
Management believes a recovery in flying hours could see free cash flow hit £750m by 2022. If this target is realised, it could generate renewed investor interest towards the shares.
Although there’s just as much uncertainty surrounding this target as the numbers outlined above, the final figures could end up being much better or worse than expected.
Still, Rolls has plenty of money available to support its turnaround. After raising additional funds from investors last year, the company has £9bn of liquid cash. This should help the business keep the lights on for 2021, at least. That’s based on current management cash outflow projections, and could be subject to change.
The group also has a strong defence business, which has helped bring in much-needed cash flow over the past 12 months.
Also on the plus side, the company has a strong balance sheet and is expected to return to cash flow probability next year. On the negative side, these forecasts aren’t guaranteed, and every day that passes, Rolls-Royce is burning cash.
As such, I’d like to wait and see what happens to the business before I buy Rolls-Royce shares. If the company can meet its target to produce a positive free cash flow by 2022, it could be cheap. However, with the company warning of that “significant uncertainty” surrounding its projections, recovery is by no means guaranteed.
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Rupert Hargreaves owns no share 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.