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Is the Rolls-Royce share price undervalued?

Image: Rolls-Royce

The Rolls-Royce (LSE: RR) share price has been one of the big losers of the pandemic. However, as the world starts to move on from the crisis, the outlook for the company is improving. As such, I’ve been taking a closer look at the business to see if it could be worth adding the stock to my portfolio as a recovery play. 

Rolls-Royce share price outlook

Rolls’ largest business is its civil aerospace division. This accounted for 41% of group revenues last year. Power systems and defence divisions made up 22% and 29% respectively. The remainder was other non-core business lines

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As the most significant division, Rolls’ fortunes depend on its civil aerospace enterprise’s profits. Revenues and profits have plunged here over the past 12 months. The grounding of the global aviation industry has forced airlines to slam the brakes on spending.

The good news is the industry has started to recover. Airlines have started to place orders for new planes again, and more aircraft are back in the sky. Rolls earns a significant amount of revenue from its engine service contracts, which are tied to flying hours. This should help power the group’s recovery in the months ahead. 

Risks and uncertainties

However, while the outlook for the Rolls-Royce share price is improving, it’s also shrouded by an incredible amount of uncertainty. There are green shoots of recovery appearing for the aerospace sector. But another wave of coronavirus could hammer the industry once again.

I also need to consider that even the most optimistic forecasts don’t expect the global aviation sector to return to 2019 levels of activity until 2024/25. That’s a few years away, and in the meantime, there’s no telling what could happen. 

Further, the company’s balance sheet is weak. Last year, Rolls had to go to investors for an emergency fundraising to shore up its financial position. If the global aviation industry suffers another significant setback, the corporation may have to go to investors for more cash once again. There’s no guarantee investors would stand by the business in this scenario. 

The bottom line

All of the above means it’s incredibly challenging for me to establish whether or not the Rolls-Royce share price is undervalued at current levels. Until we know the pandemic is truly under control, there’s no guarantee the company will be able to return to 2019 levels of sales and profitability. 

That said, in the best-case scenario, whereby sales return to 2019 levels in the next three to four years, I think the stock could be undervalued from a long-term perspective. As such, I’d buy a small amount of the company as a long-term investment for my portfolio. 

However, due to the company’s risks and uncertainties, the Rolls-Royce share price isn’t going to be suitable for all investors. 

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Rupert Hargreaves 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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