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Rolls-Royce (LSE: RR) has suffered a particularly damaging price fall over the past few years. In fact, at the start of 2018, the Rolls-Royce share price stood at around 1,000p. However, with the company forced to raise significant amounts of debt and issue equity to stay afloat during the pandemic, it has since sunk over 90%, currently priced at under 90p. After this dramatic fall, should I be adding Rolls-Royce shares to my portfolio?
The Rolls-Royce share price has underperformed the FTSE 100 index over the past year, falling around 24%. By contrast, the Footsie has only declined around 1%. However, the group’s performance has improved in this time, meaning that its recent decline may have been unwarranted.
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For one, the aerospace giant managed to recover from a £3bn loss in 2021 with a £124m profit last year. This was the result of improved demand for travel and the effectiveness of the company’s restructuring programme. There were also significant contributions from its Defence business, which accounted for around 30% of the company’s revenues.
The outlook for this year also seems fairly positive. For instance, in the first four months of the year, large engine long-term service agreement (LTSA) flying hours were 42% higher than the previous year. As Rolls-Royce is paid based on the number of hours flown with its engines, this should benefit its revenues.
Despite these positives, there are still several problems that could drive the share price down further. Firstly, at the end of 2021, the company had net debt of £5.1bn. As interest rates increase, this will become even more expensive to service, leading to further costs. Secondly, the company has negative shareholder equity, meaning that its liabilities are larger than its assets. This is a sign that the firm’s balance sheet is in desperate need of repair. It will also restrict its ability to pay dividends for the foreseeable future.
In addition to balance sheet problems, the company is also involved in a pay dispute due to the increasing cost-of-living. This has resulted in Rolls-Royce offering a cash lump sum to many of its employees of £2,000, estimated to cost the group around £45m. Nonetheless, Unite, a trade union representing many of the employees has rejected this as insufficient, leading to the possibility of further pay rises. This would have an even greater damaging effect on profit margins.
Is the Rolls-Royce share price too cheap to ignore?
Using last year’s results, Rolls-Royce trades at a price-to-earnings ratio of around 60. From this valuation alone, it seems that the share price is not great value. However, the operating environment has certainly improved since last year, and the company expects positive cash flow during 2022. Therefore, I expect that this year’s profits may be far larger than last year. This is a view echoed by Morgan Stanley analysts, who recently described Rolls-Royce as “woefully mispriced”. I share this view and therefore, I am tempted to initiate a small Rolls-Royce position in my portfolio.
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