Rolls-Royce Holdings (LSE: RR.) shares have fallen 60% over the past five years, after the pandemic largely grounded the world’s airline fleets. But we’ve seen a recent recovery extending into 2023. And the price has gained 70% since a low in October 2022.
Price recovery
I can see three reasons to buy Rolls-Royce today, and that price rise is one of them. After spending much of the past 12 months below £1, the shares now seem firmly above that level.
Investor sentiment towards FTSE 100 shares in general looks like it might finally be turning, with the index having broken past 8,000 points for the first time ever.
Sentiment towards Rolls-Royce specifically has been erratic. We’ve seen a few tentative recoveries over the past couple of years, but each one has turned downwards again. So is this general 2023 bullishness a sign of sustainable change? I suspect it’s what a lot of investors have been waiting for.
Improved trading
Rolls-Royce is set to deliver FY22 results on 23 February. And unless a lot has gone wrong since November’s trading update, things should look pretty reasonable.
At the time, the aero engine maker’s full-year outlook remained consistent. The company completed a £2bn disposal programme during the year, including the sale of ITP Aero. And it repaid its £2bn UK Export Finance backed loan, which wasn’t due until 2025.
Rolls spoke of the cost price inflation that’s hitting everyone. But by October, large engine flying hours were back to 65% of 2019 levels and up 36% year-to-date. New orders are coming in too.
Valuation
At this turning point, it’s hard to put a meaningful valuation on Rolls-Royce shares. We’ll probably see a very large price-to-earnings (P/E) ratio for 2022 once results are out. But that’s common in a year when a company is really just getting back to profits.
The valuation typically improves as earnings grow, and that’s what analysts expect right now. Forecasts have the P/E coming down to around 18 by 2024. And they show a dividend too. It would only yield around 1%. But it could be important symbolically.
On the face of it, I find the Rolls-Royce valuation attractive.
Buy?
So with all my upbeat mood, why won’t I buy? It’s simply because of debt, which I think presents danger in two ways. Firstly, it skews the apparent valuation. Rolls might have repaid that £2bn, but net debt at the interim stage still stood at £5.1bn. That takes something off that apparently low P/E figure.
I suspect the company will manage its debt well in the coming years and get a lot of it paid down. And the valuation spoiler would go away. But until then, it brings risk. The pandemic almost brought Rolls-Royce to its knees, and that was without today’s borrowings.
What if another crisis comes along soon, and Rolls has to manage it from a significantly weaker financial position? I suspect Rolls-Royce shareholders will pocket decent returns in the next few years. But I just won’t take on a balance sheet showing such high debt.
