Rolls-Royce (LSE: RR) shares have fallen nearly 50% over the past 12 months. And the late 2021 recovery has reversed into a painful retreat.
I can certainly see reasons why investors would have sold, and might still steer clear. But today, I want to look at three possible reasons for buying.
Valuation
It’s been hard to put a valuation on Rolls-Royce (LSE: RR) shares. In the struggle to get back to profit, traditional measures haven’t meant a lot.
But analysts are already predicting a return to progressive earnings. And forecasts suggest that 2022 could mark the turning point.
We’re now looking at potentially meaningful price-to-earnings (P/E) valuations. This year’s doesn’t indicate much. But a 2023 forecast P/E of 17 is starting to approach something sensible. The long-term FTSE 100 average stands at around 14-15, so it’s not far away.
And for 2024, there’s a P/E of only around 10.5 pencilled in. It’s always important to be wary of forecasts, especially in difficult times. But if it’s right, it does suggest Rolls-Royce might be a buy now.
Balance sheet
Even a year ago, I had serious doubts about the Rolls-Royce balance sheet. At the end of 2021, net debt stood at £5.16bn. During that year, it had risen by £1.58bn, clearly heading in the wrong direction.
But move forward to first-half results this year, and things already looked better. Chief executive Warren East said: “We have progressed well in the first half of the year, with more than a £1bn improvement in free cash flow…”
He added that “we are making choices to manage the current challenges, deliver better returns, reduce debt, and generate long-term sustainable value.”
Net debt was still high, but at £5.14bn, it was slightly down. Since then, Rolls has completed the sale of ITP Aero, netting sales proceeds of €1.6bn. The cash was directed to reducing debt, and I hope we’ll see good progress by the end of the year.
Cash flow
The key thing in those H1 results for me was that cash flow improved. Selling assets can only go so far in paying down debt. And, for long-term health, we need to see cash coming in.
Rolls still reported a free cash outflow from continuing operations. But at £68m, it was a lot lower than the £1.1bn outflow in the same period a year previously.
And, importantly, Rolls reiterated its expectation that it will achieve “modestly positive free cash flow in 2022“.
That’s still not what long-term success is made of. But achieving positive free cash flow by the end of 2022 has been a firm goal. And achieving it would suggest the board is doing the right things. It could just mark that turnaround point.
Buy?
I’ve said nothing here about how flying hours and engine maintenance contracts are going. Or what effects the war in Ukraine might have. Will it harm passenger traffic, but maybe boost defence sales? And I’ve ignored the general economic outlook.
I’d need to assess all of those before I decided whether to buy. Today, I just wanted to explain why I think these three key financial factors look positive.