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Here’s why I’m avoiding Rolls-Royce shares

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A Rolls-Royce employee works on an engine
Image: Rolls-Royce

Rolls-Royce (LSE: RR) shares have not being doing too well lately. At the time of writing, shares in the engine maker stand at 107p. This is far below their pre-pandemic price of 235p and more than 75% below their highs of 436p in 2014.

What happened?

The effects of the pandemic are primarily responsible for the recent poor performance of Rolls-Royce shares. Global lockdowns have left air traffic at record lows. In turn, this has led to a steep decline in the demand for aircraft engines. This has hurt Rolls-Royce significantly as engines for commercial and business aircraft is its biggest source of revenue. Such a decline in demand was reflected in the poor performance of the company’s civil aerospace business segment, which generated just £5.1bn in 2020 compared to £8.1bn the year prior.

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Overall, revenues in 2020 declined 29% year on year from £16.5bn to £11.8bn. This performance translated to the bottom line with Rolls-Royce recording a loss of £3.4bn and a massive free cash outflow of £4.2bn.

Light at the end of the tunnel?

There is some positive news, however. Last year, the company announced a restructuring of the company designed to save £1.3bn. This should help the company reduce its losses in the near term. It also raised £7.3bn by selling new shares and issuing more debt. By doing so, the company has boosted its liquidity position making the prospect of near-term financial distress much less likely.

There are also reasons to be optimistic about a recovery in the future. As the world becomes more vaccinated, the end of the pandemic is getting closer. When it does finally end, air traffic should recover to pre-pandemic levels, which should boost the demand for Rolls-Royce’s engines. In such a scenario, Rolls-Royce should recover strongly. Indeed, management are optimistic with their outlook. They estimate that the company will be free cash flow positive by the second half of this year and are targeting a positive free cash inflow of £750m in 2022.

Am I buying Rolls-Royce shares?

Despite these positive factors, I will not be adding Rolls-Royce shares to my portfolio. This is for a number of reasons.

Firstly, any recovery in the demand for aircraft engines may take years. Eurocontrol, an air traffic control body, predicts that air traffic will not recover to pre-pandemic levels until 2024 at the earliest. Such a slow recovery means that the demand for Rolls-Royce’s engines will likely remain at depressed levels for a while.

Secondly, the pandemic has left the company in a much worse position than it was before. In order to fund the huge cash burn, the company has had to issue a large amount of debt. Currently, the company has a net debt position (total debt less cash) of £3.6bn. This is huge for a company that is currently losing money.

Lastly, the company was already struggling before the pandemic. This is demonstrated by the fact that the company failed to turn a profit in three of the five years leading up to the pandemic. This does not give me confidence for the long-term future of the company. For these reasons, I am not looking to buy Rolls-Royce shares any time soon.

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Ollie Henry has no position in any 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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