Rolls-Royce (LSE: RR) shares have really not been performing well of late, so much so that the share price is now in penny stock territory.
In fact, the shares are down 20% over one year, a considerable underperformance against the FTSE 100 that’s up 7% over this time. The share price chart shows a downward spiral since October last year.
I see a number of reasons to be concerned. Any further weakness in the airline industry will have a knock-on impact at Rolls-Royce’s engines business. And we could be looking at a recession later this year, so the market could be pricing this into the shares. China’s continued Covid-related lockdowns don’t help either.
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But I’m going to dig a bit deeper first and then decide if there’s good value for me here.
Rolls-Royce’s investment case
It’s worth recognising that Rolls-Royce has a diverse business model. So, although the company’s Civil Aerospace division has suffered because of travel restrictions over the pandemic, Defence and Power Systems remained profitable.
Defence has a strong order backlog, and governments are increasing defence budgets at present. This should support Rolls-Royce’s business, at least in the near term.
Power Systems has also seen very strong order intake recently. I think the drive towards sustainable energy generation and electrification are growth catalysts for this division. Rolls-Royce has had its engines using sustainable fuels already approved for use, and hydrogen-based engine development is ongoing. Sounds promising.
Looking further ahead, Rolls-Royce could get a real boost from the UK’s nuclear energy plans. It will begin manufacture of small modular reactors to offer alternative solutions to fossil fuel-based energy generation.
Are Rolls-Royce shares unbelievably cheap?
Analysts are expecting pre-tax profit to grow almost 28% in 2022, to £240m. This would mean the shares trade on a price-to-earnings ratio of 21. I don’t consider this exactly cheap.
But I’d want to buy and hold the shares over the long term. Therefore, I’m looking further out to see what Rolls-Royce is expected to earn from 2023 onwards.
This is where Rolls-Royce shares begin to look like an attractive buy. In 2023 the company’s free cash flow (the spare cash used to pay for things like dividends) is expected to be £657m. Free cash flow is expected to grow to an even bigger £890m in 2024.
On today’s share price of 87p, the free cash flow yield in 2024 is a huge 12%. This does look like unbelievable value to me.
Having said this, Rolls-Royce shares still come with risk. There’s almost £7.5bn in debt on the balance sheet, which could be problematic if interest rates continue to rise. And any continued weakness in the aviation market will drag on the company’s profitability.
But taking everything into account, I think the 87p share price represents a good entry point into Rolls-Royce shares. The risks appear to be fully priced in, and if the company can generate the free cash flow that analysts expect, there could be unbelievable value here too. I’d buy.
